IBM hopes R&D unit an unheralded growth engine

Monday, October 17, 2005

Its engineers are expected to earn about $1 billion in service contracts this year, but the real value may be in stimulating lucrative hardware sales.

NEW YORK -- The setting was a holdover from the days of the robber barons: a grand private club commissioned by J.P. Morgan himself. But the message IBM executives delivered to 30 companies' technology officers was that many time-honored ways of doing business are long gone.

In this "flat world" age of specialized outsourcing, the IBM people argued, companies shouldn't do too much by themselves. Even research and development work at the heart of what distinguishes businesses from rivals can be opened up and spread around.

There was a subtext, of course, about as subtle as the rococo gold swirls on the club's walls: How about letting IBM do some of that R&D for you?

With International Business Machines Corp. trying to shake off pessimists on Wall Street as it heads into a quarterly earnings report, Big Blue is trying to raise the profile of its 1,400 engineers who help other companies tackle research and development problems.

IBM sees that Engineering and Technology Services unit as an unheralded growth engine. Those R&D-consulting engineers are expected to haul about $1 billion in services contracts in 2005, just three years after the group's formation.

But executives say the group's real value is that it stimulates lucrative hardware sales -- especially in the chip division, which has bet heavily on providing high-end microprocessors for IBM machines and outside clients.

The highest-profile work by the E&TS unit, as it is called, is customizing the chips that will run next-generation video game consoles made by Microsoft Corp., Nintendo Co. and Sony Corp.

E&TS also has a $100 million deal to develop military technology with Raytheon Co. and an alliance to do telecom research with Nortel Networks Corp., which has cut its own staff mightily in recent years.

The United Arab Emirates government is paying E&TS $125 million to develop automobile "black boxes" that monitor traffic and automate toll collection. The Pentagon relies on E&TS to ensure a domestic supply of top-tier chips for sensitive military electronics.

E&TS people say this is just the beginning of a push to extend the fruits of IBM's unparalleled research and development efforts -- which get nearly $6 billion a year in funding and make IBM the top U.S. patent holder -- into such fields as gaming, aerospace, defense and medical devices.

It's also part of CEO Sam Palmisano's broader goal for IBM to unfurl myriad "business performance transformation" services, in which consultants reshape everything from customer service to managing payroll.

Just like those tasks are being shifted to efficient specialists, IBM says, so can researching new technologies and developing new products.

"If you're doing R&D, and if you're not world-class, then you'd better let it go," said Irving Wladawsky-Berger, IBM's vice president for technical strategy and innovation.

Outsourcing or partnering on R&D can be risky. If companies pass off too much design work, they could lose internal expertise and control. And the arrangements require careful discussion about who owns any jointly developed intellectual property.

But E&TS wins praise from analysts, who say it appears admirably discreet about its work. And several customers say they jumped at the chance to tap IBM's engineering prowess.

Raytheon signed on before even deciding precisely what the companies would work on together, said Peter Pao, Raytheon's chief technology officer.

Mercury Computer Systems Inc. sought out IBM after hearing about the monster performance of Cell, a new graphics-intensive chip jointly designed by IBM, Sony and Toshiba Corp. Now Mercury plans to tweak Cell chips with IBM's help for medical-imaging and defense systems.

"We knew about Cell, and we made them tell us," said Craig Lund, Mercury's chief technology officer.

It might not always be so easy to win customers.

There are only so many organizations that need such high-end, custom technology. For less complicated projects, there are many competitors, from companies that design application-specific chips to lower-cost offshore service vendors.

For instance, India-based Wipro Ltd. has a product-design services group with 10,000 engineers -- mostly software experts -- and $400 million in annual revenue. Its customers have included almost all of the world's top telecom equipment providers.

"The challenge for IBM is how do they get a significant share of this market," said analyst Navi Radjou of Forrester Research. "For IBM, this is going to be very nasty."

Radjou suggests that eventually E&TS might benefit from partnering with offshore providers like Wipro.

Big Blue's engineering and patent heft would launch projects, and less expensive developers would help integrate pieces of them. Indeed, Ayan Mukerji, who heads Wipro's product-engineering business in North America, said he sees "more areas of collaboration rather than competition" with E&TS.

But E&TS is unlikely to farm out any of its projects, lest that weaken its blue-chip brand and ties to customers. "It flies against their model," Radjou said.

Another question is whether even a giddily successful E&TS could drive dramatic growth at IBM, simply because of the law of large numbers.

IBM's revenue will be around $93 billion this year, down slightly because of the sale of the PC division to China's Lenovo Group Ltd. At such heights, to grow even at a modest 5 percent would require finding nearly $5 billion in new sales, the equivalent of an entire Fortune 500 company.

"A lot has to go right at the same time for the needle to get moved," said analyst Richard Petersen of Pacific Crest Securities. "That's why it's a tough stock."

Largely because of such sentiment that IBM will be reliable but unspectacular, its shares have dropped 17 percent in 2005, closing Thursday at $82.20. The stock hit a 52-week low of $71.85 in April.

While IBM doesn't quite suggest E&TS could single-handedly produce blockbuster returns, Satish Gupta, who heads the unit, says the company hasn't done enough to talk up the group's opportunity.

"The world has changed," he said. "Collaborations like these are much more crucial to the future of our business."

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