September 18, 2004
JPMorgan Chase & IBM’s $5 Billion Shrug: Palmisano’s Strategic Collapse or Really No Big Deal?
Back in December 2002, when the financial services company announced the seven-year, $5 billion deal to outsource much of its data processing to the world's largest computer company both companies bragged that the contract - the largest of its kind for IBM - would reduce costs, create value and propel innovation at J.P. Morgan. Today, both companies are downplaying the termination.
IBM put a positive spin on the cancellation, stating that it would actually help its 2005 earnings. JPMorgan Chase likewise said the cancellation would have no material impact on its business. The bank noted that IBM remains a key technology partner and provides IT services and products to a number of its businesses. The functions to be reintegrated back into the bank cited by the two are "the previously outsourced portions of its technology infrastructure, including data centers, help desks, distributed computing, data networks and voice networks." IBM said the cancellation could improve earnings because it was still in the early stages of deployment on the contract. It also said its backlog of services will be revised when it announces its third-quarter earnings. IBM estimated a $118 billion services backlog at the end of the second quarter.
Fewer all-encompassing technology services deals are expected in coming years as competition pushes down the size of these agreements, and customers consider doing more themselves. In turn, services providers like IBM are looking to sign more pacts for individual projects like software or data.
Bank One decided to bring its information technology in-house several years ago and has spent over $1 billion to upgrade its entire technology suite, including building data centers. This philosophy has now taken hold at J.P. Morgan.
Plus, this week JPMorgan's president and chief operating officer, Jamie Dimon, announced the opening of two new data centers in Delaware. The $300 million investment will add 100 jobs and support the bank's national network.
Here's an excerpt with some further detail:
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Executives at IBM Global Services must have cringed earlier this year upon hearing that J.P. Morgan Chase had tapped Jamie Dimon as its president and chief operating officer. As CEO of Bank One Corp., Dimon scrapped a $2 billion IT outsourcing contract the bank had inked with IBM and AT&T in 1998 under a much-ballyhooed "Technology One" alliance.
Dimon canceled that deal in 2002. Now, he appears to have done it to IBM again.
Industry watchers see Dimon's fingerprints on Chase's decision, announced Wednesday, to cancel the company's $5 billion, 10-year "business-transformation-outsourcing" contract it signed with IBM in late 2002. "After the Bank One experience, he's become a big believer in doing things in-house," an analyst says.
Indeed, Dimon publicly said in 2002 that Bank One's outsourcing experience "hadn't worked out" and that henceforth it needed to "control its own destiny." Dimon joined Chase as a result of its merger with Bank One, which was completed in July.
In a Chase press release issued Wednesday, a statement attributed to CIO Austin Adams uses language similar to Dimon's to explain why Chase nixed its outsourcing contract. "We believe that managing our own technology is best for the long-term growth and success of our company," Adams said in the statement.
Chase says it plans to reel in the 4,000 IT workers it dispatched to IBM under the defunct deal and take back a number of ongoing IT projects.
For its part, IBM is looking to put a positive spin on the news, noting that the contract required substantial up-front investments that would have placed a slight drag on its earnings this year. However, $5 billion in revenue isn't easy to make up. One Wall Street watcher says the loss of the contract should cost IBM about 2 cents per share in annual earnings over what would have been its remaining years. The analyst notes that IBM will enjoy some fees that Chase will be obliged to pay as a result of its decision to cancel the deal.
JPMorgan Chase wanted to get the most out of its newly acquired Bank One assets as well:
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Spokesmen say the move actually was based on a desire to make full use of IT assets and processes the company acquired through its July merger with Bank One, which "really changed the equation" in terms of effective IT use, says executive VP Charles Costa.
The financial-services company will have access to a state-of-the-art data center that Bank One opened in Wilmington, Delaware, last week at a cost of $150 million, says Costa, J.P. Morgan Chase's executive VP for global technology infrastructure. Among other things, the building features dedicated fiber-optic lines and new server and storage systems. "This didn't exist for us" when J.P. Morgan Chase struck its outsourcing deal with IBM in 2002, Costa says, adding that the company is better served assimilating Bank One's advanced IT assets than turning them over to IBM to manage.
Bank One's IT capabilities also will help J.P. Morgan Chase meet tech-driven business requirements, such as the Check 21 initiative that lets banks process checks using graphic images instead of paper. "That's a big priority that we need to be well positioned for," Costa says. Last year, Bank One rolled out a system that converts consumer checks into electronic debits for next-day settlements using high-speed imaging.
Bank One recently completed a $500 million initiative to standardize and centralize its IT systems, an effort that's expected to shave $200 million from its annual operating costs by, among other things, eliminating 600 software applications and reducing 11 loan systems to six. "The merger really changed the equation, and Bank One's technology infrastructure is a key part of that," Costa says.
In my opinion the deal's falling apart is really a philosophical shift more than anything and this is somewhat of a blow to IBM's grand corporate strategy of providing technology services to companies large and small around the globe. The 2002 contract was the centerpiece of IBM's transformation from a technology manufacturer to a technology manager, a strategy devised and overseen by the chief executive, Sam Palmisano. The contract with JPMorgan was among the largest such outsourcing contracts ever signed; only a $6.9 billion deal won by Electronic Data Systems to manage information technology for the U.S. Navy was larger. Trying to put the contract loss in the best possible light for IBM is still tough. "The combined firm found itself with an abundance of IT assets," an IBM spokesman, James Sciales, said. "This decision was like other business decisions related to the merger."
The announcement makes me (and much more influential analysts) wonder whether IBM's technology outsourcing strategy - its response to what it calls the on-demand era - is as promising or as profitable as the company has led investors to believe.
"This was Palmisano's grand vision, and this was the reference account," said Fred Hickey, editor of The High-Tech Strategist, an investment newsletter in Nashua, New Hampshire. "This whole on-demand strategy kicked off just a couple of years ago was predicated on these kinds of large accounts they were going to win. Now, not very long after starting it, they're pulling it back. You have to question whether this strategy is going to be successful or if services will be, as Sun's Scott McNealy says, the graveyard for old tech companies that can't compete."
There is no denying that IBM's future is heavily reliant on success in Global Services. Revenue from that unit now accounts for half of IBM's sales, which totaled $89 billion in 2003. Hardware revenue was roughly a third of the company's total sales in the first half of 2004, reflecting IBM's recent exit from the disk drive, consumer PC, semiconductor and chip-packaging businesses and software sales accounted for just 15 percent of revenue.
However, after IBM's decade-long push into services, revenue growth in the unit is slowing and services revenue rose only 2 percent in the second quarter of 2004, compared with the prior year's revenue growth of 9.3 percent.
Indeed, throughout 2003, Global Services provided the only bright spot for IBM in revenue growth, after software sales rose only 1.9 percent last year and hardware, financing and enterprise investments all declined. While services dominate IBM's revenue, gross profit margins in the business - at 25 percent in the second quarter - are the lowest at the company.
Sciales said that the cancellation of the deal has not caused great concern at the company over its on-demand strategy, but IBM is not the only company that has encountered problems with long-term contracts. EDS, its chief rival in this business, has struggled with some of its largest contracts and Cap Gemini, a competitor in Europe, has also had some big problems.
Long-term contracts like these are almost impossible for investors to assess for profitability because, under accounting rules, the companies devising the contracts have wide license in the expenses they can assign to the business during a given period. If expenses are underestimated, the contracts look a lot more profitable than they really are.
The final contradiction cannot be avoided… to paraphrase one analyst, IBM has been touting its on-demand strategy and how great their backlog is as a result, but if losing this contract is a good thing, how can getting more of these contracts also be a good thing?
- Arik
Posted by Arik Johnson at September 18, 2004 03:26 PM | TrackBack
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