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February 28, 1994

WELCOME TO THE ARMONKEY HOUSE: THE INMATES ARE BACK IN CONTROL

By CBR Staff Writer

IBM Corp’s fourth quarter figures made it clear that the relief on Wall Street that the company appears to be on the mend is sadly misplaced, but the share price still does not reflect the company’s current parlous state because far too few analysts, let alone investors seem to be able to distinguish between the gross gross margins that the company used to make on mainframes when mainframes were a growth business, and the margins that are so slim as to represent losses at the net level after IBM’s still bloated overheads are taken into account in the two businesses that are growing, personal computers and computer services. The March issue of Upside magazine features an open letter to chairman Louis Gerstner from Charles Ferguson and Charles Morris, co-authors of the book Computer Wars, in which they pull together all the worms eating away at IBM’s innards that have been highlighted here over the past few months, and by aggregating them create a disconcertingly bleak picture of the prospects for the company. They also add one or two assertions that were new to us, notably that according to Bank Letter, when IBM secured that $10,000m credit line in November, it had actually been looking for $12,000m, but the banks baulked at putting up such a huge sum – and that Bankers Trust and CitiCorp sat on their hands and refused to participate at all.

Hidden nasties

There are three points they make that stand out most starkly. IBM is now in a far weaker state to withstand any kind of setback now than it was when it ran into its most recent major crisis, in 1992, when it finally dawned on Armonk that the recession in the mainframe market was not simply a function of the world economy, and that the glory days really were gone for good. The authors point out that the debt-to-equity ratio is already at 1.5 to 1, dangerously high for a technology company that has to invest heavily in research and development to secure its future. They guess that it will have reached 2:1 by 1995. The second point is that despite the clear-the-decks $7,000m $8,000m – $9,000m – hit taken in the summer, there are still further write-offs to come, which is why the debt-to-equity ratio is so important. The authors say that the company still has not written off its East Fishkill, New York semiconductor plant and they are deeply suspicious that there are some serious hidden nasties in the leasing area. They point out that IBM’s response to criticisms of its level of debt is to point out testily that almost all IBM debt is secured by leases and ask, if so, why has IBM not spun off the finance subsidiaries and got the lease-related debt off its balance sheet? They then speculate that it can’t, because IBM’s marketing departments are using concessionary leases to mask big price cuts and because it is witholding from the second-user market equipment returned off lease so as to keep mainframe prices up – using its balance sheet to maintain mainframe prices – setting up a nasty accident waiting to happen. The third point is that Gerstner is quietly reversing all the crucial reforms that his predecessor John Akers belatedly put in place at the end of 1992 – Armonk has long been likened to the Kremlin, and absurdly, the parallels continue: the old guard has been pardoned by the Parliament and is back in power. It is often said that the worst fate than can befall a commentator is that his recommendations are adopted but we would very much prefer to have continued to suffer that fate than to have to watch the whole edifice being destroyed. The irony is that – much too late – the endlessly maligned John Akers had finally started to get things right when he moved to break IBM up into semi-autonomous units that crucially would keep their own books so that the world – and, more important, Armonk, could finally see what was truly profitable and what was not.

Sell another mainframe

The names stuck onto some of the units may have been absurd, but the concept was right. Now Gerstner has reversed all that, and one consequence the authors highlight is that it will be very mu

ch harder, if not impossible, to spin off a big business in a timely fashion when the next cash crisis strikes. The authors highlight IBM’s Powerparallel RS/6000-derived systems as one of the hot properties for the future: we’ve never got very excited about these, and now we realise why. Bitter experience has taught us that there is no point in getting excited about any IBM development that appears to be a genuine technical and commercial breakthrough because IBM will never devote the necessary resources to make it a success if there is any chance that it might sell another mainframe instead. Among the most genuinely innovative things to have come out of IBM over the past three decades are the VM operating system, which a decade ago could have been turned into IBM’s answer to Unix, and the System 38. We got excited about both in the late 1970s and early 1980s, but VM is now on the scrapheap, and System 38 spent 10 years in limbo before it was finally given its place in the sun as the AS/400. We had thought until the fourth quarter figures came out that AS/400 was the one jewel left in IBM’s systems crown, and have warned repeatedly over the past three years that IBM risked losing that market too if it did not devote more attention to ensuring its survival.

Deaf ears

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Now we are persuaded that it is too late: sales are declining, the move to a RISC-based architecture is too little, too late and we all know how seldom major IBM projects like that one come in on time, let alone on budget – and that the AS/400 is inexorably headed down the same primrose path as the mainframe. Returning to the two Charleses, authors of the Upside open letter, they (clearly rightly) castigate IBM for squandering most of its research and development dollars on trying to create the absurd parallel MVS machine, on the project to move the AS/400 to a RISC architecture, and on OS/2, where they suggest that the sales claims for OS/2 are mostly fictional since it is given away almost free, and the level of installation is far too low to amortise the investment and promotional costs – while the final break with Microsoft will ensure that Microsoft will do to IBM what IBM has tried to do to the IBMulators for so long make it impossible for OS/2 to retain compatibility with future Windows releases. They conclude with a long list of recommendations – break up the integrated sales force, which they say, unbelievably still pushes first the mainframe, then the AS/400, and only then the RS/6000 to customers for whom only a Unix system has any chance of winning the business; clean up the balance sheet; stop wasting money on obsolete product lines and invest in the future – PowerPC, RS/6000, Powerparallel systems, small disks, chips that the market needs; break up and pare still further the sales force; get rid of the old guard at the top and bring in experts to run the OEM and chip businesses; settle on one open operating system for the future instead of spreading development dollars too thinly over MVS, OS/400, OS/2, AIX, Taligent; and run the mainframe and AS/400 businesses so as to maximise profit. The prescription looks to be essential and almost totally unexceptionable – yet only one thing is certain: it will fall on stone deaf ears.

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