Big Blue skies

IBM: IBM is now the second most valuable tech company, behind only Apple, after surpassing Microsoft’s market capitalization this week. It has been a tortuous reversal of fortune. Big Blue’s pitiful state in the early 1990s forced it to refocus. Flush rivals like Hewlett-Packard, Cisco and Microsoft followed different paths, which now have them trying to find their way. That leaves IBM in position to sustain its march on the industry.

When Lou Gerstner took over as IBM’s boss in 1993, the collapse in demand for mainframe computers had left it hemorrhaging money. So the company shifted its emphasis to software and services, which have proven more resistant to the steady price declines generally ordained by Moore’s Law. Analysts reckon hardware will account for only about 15 per cent of IBM's sales this year, and less than 5 per cent of profit.

Moreover, IBM has plowed a big chunk of its earnings — more than $30 billion worth over the past decade — into buying smaller firms, mostly in software and consulting. Returns in the programming business are high and steady, and IBM has slashed costs and generally appears to have put its cash to good use. The software division’s pre-tax margins are above 30 per cent.

While IBM benefited from hard choices, big rivals suffered from their easy money. Microsoft and Cisco branched out into areas like consumer electronics. That proved to be poor capital allocation. HP, meanwhile, increased its focus on hardware and largely overlooked software. IBM investors have seen the value of their investment soar 17-fold since 1993, and HP's only six-fold by comparison.

IBM shows no reason to relent. Microsoft isn't giving any sense it yet knows what to do with its funds. Witness the $8.5 billion it has splashed out on Skype. HP’s new boss just slashed the company’s full-year outlook. Cisco is only now getting around to shaking things up. The upheaval may ultimately pay off, just as it did for IBM. Big Blue already trades at 13 times estimated 2011 earnings, a premium to its three big tech rivals. The advantage should be sustainable for a while.