IBM cashes in

The deals have clicked with regularity since March: Dell Computer Corp., EMC Corp., Acer Group, 3Com Corp. and Cisco Systems Inc. With more than $30 billion committed to its coffers from these and other contracts, the IBM Technology Group is just getting started.

Not even a year old, this new division has an ambitious goal: Become the arms dealer to the IT industry. To reach that pinnacle, IBM is leveraging the industry's broadest patent portfolio—along with the specter of enforcing those patents.

Now, as IBM continues a transition that will significantly impact technology vendors and their customers well into the next decade, the company finds itself walking an increasingly fine line between supplier and competitor to its partners.

To propagate its technology throughout the industry, IBM has had to open up its closely held intellectual property—the crown jewels spawned from years of R&D.

In the past six years alone, IBM has registered more than 10,000 patents, covering security, cryptography, software, storage, networking, PC and server architectures, and semiconductor design and manufacturing.

That diverse portfolio of technology often languished in IBM's labs as the company's hardware and software divisions failed to build and market successful products around it.

"We used to keep wraps on our technology, designing and building something without knowing if there was a market for it," said Jim Vanderslice, senior vice president and group executive of ITG, based in Somers, N.Y. "Now it's completely different. We're offering more access to our technology for a better return."

A better return is just what it's getting. For the first six months of this year, ITG has taken in $7.7 billion in revenues, with $5.8 billion of those sales coming externally (the rest of the revenues are derived from component sales to other IBM divisions). Its goal: $19 billion in outside sales by 2002.

"Of all the computer companies, IBM's inability to capitalize on its wealth of technology was probably the most baffling," said Marcia Brooks, contributing editor of the Inside the New Computer Industry newsletter, in Carmel, Calif. "ITG may be dismissed as a move to make IBM a mere supplier of parts, but the fact is, the company is going where the margins are."

R&D gauntlet

The charge has been led by IBM Chairman and CEO Lou Gerstner, who early last year challenged three senior executives—Vanderslice, Bob Stephenson and Mike Attardo—to find a way to offset the company's R&D costs. At more than $5 billion annually, IBM's R&D expenditures are nearly as much as the R&D budgets of Intel Corp. and Microsoft Corp. combined.

At the time, IBM's OEM initiatives consisted mainly of selling mass storage. After months of research, the three executives concluded that the best way for IBM to leverage its R&D investments was to become a full-fledged component supplier and integration partner to third parties.

Such a move, the executives reasoned, would also buttress IBM's hardware revenues, which have slowly but steadily declined. More important, it would give IBM a way to enforce its patents without chasing down vendors for royalty payments.

In August 1998, the trio presented its findings to IBM's board of directors in the report "IBM's OEM strategy for the 21st cen tury." The board signed off on the plan, and two months later, ITG was born, combining IBM's storage systems, microelectronics, printing and network hardware divisions.

Less than a year later, the deals are piling up with alarming speed. One main reason: Many vendors want to repel the threat of a patent infringement battle. IBM's patents are so extensive and cover such fundamentals of computing that it would be virtually impossible to find a company that has not infringed upon one of its patents at one time or another.

"We needed to get the royalty issues off the table," said Michael Lambert, senior vice president of Dell's enterprise computer group, in Round Rock, Texas.

Dell had been paying tens of millions of dollars annually to IBM as part of a 1993 royalty agreement that expired in late 1998. Eager to drop the fees and apply the cash to its bottom line, Dell began negotiating its component deal with IBM in early 1998 and finally consummated the landmark $16 billion component pact in March of this year.

"Patent infringement is always an issue with IBM, given their extensive portfolio," said a Dell executive, who requested ano nymity.

The same scenario played out between IBM and EMC, whose existing royalty agreement also expired late last year. After months of negotiation, EMC in March agreed to purchase $3 billion in IBM disk drives in a cross-licensing deal that resolved the patent issues.

"There was a very strong potential" for a legal dispute had the two sides not reached a new agreement, said Paul Noble, executive vice president of products and offerings at EMC, in Hopkinton, Mass.

"Both [companies] were of the opinion that, rather than litigate ownership of particular technologies and licenses to technologies, we'd have a partnership," Noble said, adding that EMC wanted to design next-generation storage systems without fear of patent infringement. Now, he said, "we have what we wanted: design freedom."

Similarly, Cisco and IBM for years disputed patents and threatened lawsuits. Earlier this year, the two signed a cross-licensing deal to settle some of those disputes. The deal was a precursor to the $2 billion pact announced earlier this month.

"IBM uses intellectual property to their advantage to strike a deal in some other manner," said Selby Wellman, senior vice president of Cisco's Interworks Business Division, in Raleigh, N.C. Wellman, who negotiated the IBM deal for Cisco, added that such methods are standard strategy for many high-tech vendors, not just IBM.

Tony Baker, ITG's director of business development, acknowledged that protecting intellectual property plays an important role in ITG's licensing deals.

"Getting a return on that [intellectual property] is a very active program at IBM," Baker said. "You can sometimes run into areas of disagreement [over royalties], and we want to remove a potential inhibitor to a relationship. We want to take away any contention."

Beyond the patent issues, ITG's partnerships are having a major impact both inside and outside IBM. The company effectively exited the networking hardware business by selling its routing and switching patents to Cisco. The strategy shift raises questions about the future of other IBM divisions as well (see story, below).

However, the deals also help IBM keep revenues flowing into other divisions. As part of Cisco's pact with IBM, for example, the networking giant agreed to purchase IBM storage and PCs.

"They get you to [agree to] buy more products from them, [so] they'll issue a cross license," Wellman said.

Externally, the partners could help bring to market more quickly such IBM advancements as copper-based semiconductors, remote management software, high-capacity storage products in small form factors and silicon-on-insulator technology.

Nintendo of America Inc., for example, will use custom-made "system-on-a-chip" semiconductors from IBM in game devices due to hit the market during next year's holiday season.

"This is not a simple buy/sell arrangement anymore," Baker said. "We will work with partners to 'forward integrate' our technologies into their products."

That "forward integration" strategy provides perhaps the point of greatest potential conflict between IBM and its partners. For IBM to develop or customize components for partners' future products, it must be privy to those partners' long-term product plans.

Companies such as Dell and EMC are wary of sharing such confidential information with IBM, fearing their road maps will fall into the hands of rival IBM product divisions.

"Rest assured we have no intention of broadly communicating our plans to IBM," said the Dell executive who requested anonymity, even though Dell will likely have IBM build custom ASIC (application-specific integrated circuit) chips for future devices.

EMC and IBM, No. 1 and No. 2, respectively, in enterprise storage, will continue to walk a tightrope of sharing technology while competing in the storage market. IBM's latest storage system, Enterprise Storage Server, which the company calls its "EMC killer," is not covered by the technology-sharing agreement. EMC executives say they're not concerned about IBM cloning EMC products, even though the deal gives IBM access to patents for EMC's flagship Symmetrix line.

"Having a clipboard and a basketball doesn't make you Michael Jordan," Noble said, adding that it's unlikely the two will actually co-develop products.

"It is a delicate balance in adhering to confidentiality," ITG's Baker said of the cross-licensing deals. "The reality of the matter is that your credibility and reputation are on the line. If you violate the agreement, it's over."

Baker says ITG signs nondisclosure agreements with partners to ensure that confidential information stays within the technology division.

The benefits of the agreements—particularly partners' abilities to cut down on their own R&D expenditures by leveraging IBM's labs—should outweigh any risks, IBM officials maintain.

"Lots of companies are becoming just distributors of technology, so they'll need us to offload their R&D cost in this commodity market," Vanderslice said.

IBM's moves, as a result, could have a chilling impact on other component companies, which already are struggling with declining storage prices.

Last week, mass-storage maker Seagate Technology Inc. said it would cut 8,000 jobs and post a loss for its current quarter. Likewise, Western Digital Corp. and Quantum Corp. have cut jobs recently in an effort to offset poor financial performance.

"IBM provides incentives for Acer to buy as much as possible, such as price discounts," said Stan Shih, chairman of Taiwan-based Acer Group, which signed an $8 billion deal with ITG in June.

IBM could have bigger fish to fry than component vendors. Its OEM efforts position Big Blue as a much worthier competitor to Intel. Both companies, for example, are entering what's expected to be a lucrative market for programmable communications processors.

The jabs are already starting to fly, even before the companies release their respective network processors.

An Intel executive last week criticized IBM for building too many functions into its forthcoming network processors, resulting in a bloated chip.

"Their die is bigger than Merced," Intel's forthcoming 64-bit processor, said Mark Christensen, vice president and general manager of Intel's Network Communications Group, in Hillsboro, Ore. "They can't scale down, but we can scale up."

The risks and competition have yet to hamper ITG's progress. As the division forges new alliances almost monthly, one thing is clear: IBM's building blocks of components, software and services, and not its mainstay hardware, are the backbone of the company's 21st-century growth strategy.

"Gerstner changed their culture, and that's not an easy thing to do," said Cisco's Wellman, who spent 15 years at IBM. "It's a different IBM today."

Added Baker, a 30-year veteran: "We have to be more open because we're not just a hardware supplier. We used to be paranoid about eating our own children, but today, there's not so much paranoia about giving away our secrets. If we don't do this, someone else will."

Additional reporting by John S. McCright

Let's make a deal: A look at some of IBM's biggest OEM partnerships to date

Fact file: IBM's patent portfolio

IBM has been the leader in patent awards for six consecutive years

2 million registered patents since 1971

3,000 software patents since 1993

Awarded 2,682 patents in 1998—the first ever to break 2,000 patents in a single year

700 patents awarded in 1998 were related to software

375 were related to network computing

Several dozen were related to silicon-on- insulator and silicon germanium technology

About 30 percent of IBM's patents are represented in products

Patents generate about $1 billion annually in revenue for IBM

Source: IFI/Plenum Data Corp., IBM