Taking Stock: IBM Picks A Rose With Latest Buy

IBM (IBM -- NYSE) entered the application development and deployment business earlier this month with plans to acquire Rational Software Corp. (RATL -- Nasdaq) for $10.50 per share in cash, or a 29% premium over Rational's closing price. To IBM, the required $1.7 billion payment is like you or me buying a car. The vendor generates about $2.5 billion in cash flow from operations per quarter, and it has about $5 billion in cash on the books.

Unless you've been hibernating through the past decade, you know IBM no longer depends on PCs and mainframes. That's a good thing, given the competition. Gross margins were 40% in IBM's hardware division in 1991; today, they're 28%. Hardware also has been a slow-growth business and represented only about 5% compounded annual growth over the last 10 years for IBM. Services account for 41% of revenue, double that of the last decade. This illustrates the need for technology companies to not only sell products but also help customers implement them.

The implementation of hardware necessitates strong software platforms, and IBM has moved aggressively into this business over the past few years. Rational is the latest addition to the strong software slate, which includes Tivoli for E-business infrastructure management, DB2 for database management, WebSphere for E-business platforms, and Lotus for collaboration and communication.

Rational, founded in 1981, tackles the challenges many companies face in software development: Projects often fail to meet their objectives in timeliness, functionality, or cost. Rational offers processes and tools that can improve project predictability and reduce risk. Rational's configuration- and change-management offerings are used during the development cycle for revision control, project and process management, and requirements management. It leads this $800 million-a-year market, followed by Merant Inc. and Serena Software Inc.

In visual-modeling, Rational's Rose lets users more easily design software by turning requirements into technical building blocks. Rational leads this $600 million-a-year market, followed distantly by Computer Associates, Oracle, and TogetherSoft.

Testing and management tools are critical in developing software, and Rational has many products, though it trails Mercury Interactive Corp. and Compuware Corp. in the $1.1 billion-a-year market. IDC estimates that Rational's markets will double by 2006.

IBM believes it can sell Rational's products through the significant IBM client base and via IBM's 10,000-strong sales force. There's little overlap with IBM's products, and Rational fills a big gap in IBM's software infrastructure portfolio. In addition, Rational's largest industries include electronics, telecom, and military aerospace, while IBM has significant exposure in finance, insurance, retail, and health care -- all areas in which Rational could make inroads.

IBM's recent run-up in price reflects the expected upturn in technology spending next year. Whether that occurs remains to be seen, but 3% to 4% growth across most technology sectors is likely. This isn't a ringing endorsement for IBM's share price, which trades at 19 times next year's $4.31 earnings per share, in the near term. However, IBM's continuing march into faster-growing areas such as software and services should help drive the stock higher.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected].