<THE RULE MAKER PORTFOLIO>

Benchmarking Big Blue

by Rob Landley (TMF Oak)

AUSTIN, TX (May 14, 1999) --

"I compute, therefore IBM."

I'd like to wax enthusiastic about my largest personal holding. It's the biggest, most well-established computer corporation on the planet, a cutting-edge research lab that makes Lucent's "Bell Labs" or Xerox Parc green with envy, a services corporation that Fortune 500 companies can outsource their entire IT departments to, and the world's biggest Internet start-up. I used to work there. You may have heard of it. It's called International Business Machines (NYSE: IBM).

In 1992, IBM's stock crashed. After decades of heady monopoly, Big Blue's customers were fed up and found an alternative. The aging mainframe behemoth, overrun by bureaucracy and middle management, was bleeding red ink. Its bread-and-butter mainframe systems were replaced by cheap, ubiquitous, networked PCs on every desktop. Seemingly desperate, IBM brought in a new CEO, Lou "The Cookie Man" Gerstner, a former Nabisco executive who didn't even pretend to know anything about computers. The unthinkable occurred as layoffs swept the company. Things looked bleak for the ex-monopoly.

Lou Gerstner may not have known computers, but he knew how to run a business. Since then, IBM's stock has increased almost 50% per year, and with good reason. According to its most recent (May 13) income statement, year-over-year net income was up 42%, and in that time, the stock buyback plan repurchased and retired 76 million shares. As a result its fully diluted net earnings per share were up 47% year-over-year. This wasn't just a turnaround, but a complete reinvention of what the company did for a living and how it did it. The Cookie Man done good.

But IBM doesn't belong in the Rule Maker portfolio for two simple reasons. First, its gross profit margin is only around 36% and declined slightly in the last quarter. Second, it has $30 billion worth of debt, which expanded slightly in the last quarter. While IBM is a healthy, growing company that is profitable, good at what it does, and well managed (in my opinion), it's not a very "light" business, and its management is quite happy to "use leverage" and go into debt when the company has more opportunities than cash available to pursue them. I really like the company, but it doesn't fit this portfolio's criteria.

Here's the ranker for Big Blue -- a not-too-hot 26 points -- a Tier 4 company.

That doesn't necessarily make it a bad investment. A Rule Breaker isn't a Rule Maker, and the RP4 Foolish Four portion of our portfolio is full of companies that are neither. I like IBM because it's good at what it does, and because the growth opportunities available to it are amazing.

IBM's once-disparaged mainframes are now mighty Web servers for Fortune 500 companies, and selling like mad. But if you can't afford a traditional mainframe, IBM would be happy to set up a PC cluster like the Linux Beowulf cluster it demonstrated at LinuxWorld Expo in March, hooking together 17 Netfinity servers to match the performance of a Cray supercomputer. IBM may not have a monopoly on high-end computing, but it's established, profitable, and there to stay.

IBM already gets a quarter of its revenue from the "electronic business" that everybody's trying to cash in on. They're not planning it, they're doing it. The Internet is central to IBM's strategy -- not just in the future, but in the here-and-now. Again, IBM may not own e-commerce, but it's a big player and getting bigger.

IBM's research labs continue to astound, and IBM has been granted more patents than any other company for each of the last six years. Those patented innovations feed off each other very nicely. For example, last year IBM was the first company to figure out how to create microchip circuitry using copper, which is a better electrical conductor than the traditional aluminum. They also developed a "silicon on insulator" technique which reduces electrical leakage between circuits, allowing them to run with less electricity (and thus less heat). And in another lab, IBM researchers came up with a microchip design that ran at 1000 Mhz using a (now very obsolete) 0.25 micron manufacturing process. Put the three together, plus the normal advances in CPU design over the past year, and IBM's got one heck of a chip on its hands. These technologies make possible faster, smaller, longer-battery-life computing devices. IBM may not unseat Intel, but that doesn't stop it from making a lot of money in microchips.

Years ago, IBM invented the hard drive. In February, it announced an inch-long hard drive that stores 340 megabytes of memory and can fit in a wristwatch. On Wednesday, IBM's researchers announced they had just tripled their old hard drive data storage density record, and can now store two and a half gigabytes on each square inch of hard drive platter surface. They may not be putting Western Digital out of business, but they're still in great shape.

This is the company that made the "Deep Blue" chess computer that beat Gary Kasparov, arguably the greatest human chess player in history. Those copper microchips I mentioned earlier will power Nintendo's next generation "Dolphin" video game system, and IBM's Microdrives mounted in PCMCIA type II "flash memory" cards are compatible with many of the new portable MP3 players coming on the market, as well as established flash card uses like digital cameras. While Microsoft is still trying to diversify away from the Windows and Word duo that produce the bulk of its profits, IBM has already diversified far beyond its old bread-and-butter mainframe. Yes, it accepted lower margins to do so, but the result is a far more stable business model.

As for the "light" elements of IBM's business, they're pushing hard into services. In the first quarter of this year, IBM signed almost $10 billion in new services contracts, bringing its total services contract backlog up to around $55 billion. Software did well too, with revenues up 10% for the quarter to almost $3 billion, compared to Microsoft's $5 billion total corporate income in the December quarter, and Oracle's paltry one-third of a billion barely registering. A few years back, IBM acquired Lotus, and has continued making periodic smaller acquisitions of software companies like Tivoli. Its in-house software researchers are on the cutting edge of speech recognition, data compression, and encryption. IBM is a leading proponent of Java, and has bought into Linux wholeheartedly (with the near-obligatory equity investment in Red Hat), while still selling Microsoft NT servers if that's what the customer wants.

IBM and Dell recently signed a $16 billion, seven-year contract giving Dell a steady supply of IBM storage, networking, microelectronics, and display components to build into its PCs, and granting IBM access to Dell's build-to-order manufacturing and distribution processes. Having personally experienced the prototype for the antitrust trial currently leveled at Microsoft, IBM is happy to form mutually beneficial relationships with other companies rather than try to put anybody else out of business and find itself in the spotlight again.

IBM may not be #1 in any particular segment of the computer industry, but it's #2 in almost all of them. It's happy to use its own in-house resources, or partner with others to get the job done. That diversity and flexibility are IBM's greatest strengths, allowing it to provide integrated solutions to customers. The high debt and low margins may eliminate it from our portfolio, but I'm quite happy to own a big chunk of the company in my own.

For more on IBM, check out these stories:

And if I haven't left you with enough to read, this has been an active week in Fooldom with lots of special features. I especially recommend our interview with Buffett author Robert Hagstrom -- a very interesting discussion about the advantages of a concentrated portfolio.

Finally, Yahoo! broadcast its annual shareholders' meeting live via webcast today. Check out the replay at this link on broadcast.com. CEO Tim Koogle gives an interesting presentation. Here's a quote to whet your appetite:

"I learned long ago to take care of the balance sheet, and you can prevent a lot of future surprises."

Have a great weekend!

Oak

05/14/99 Close

Stock Change    Bid
AXP   -4        120.75
CHV     ---      94.44
CSCO  -2 1/4    115.44
EK    -1 7/16    77.63
GM    -2 7/8     83.13
GPS   +  9/16    62.63
INTC  -2 1/16    58.00
KO    -  1/2     65.25
MSFT  -2 1/4     76.88
PFE   -4 5/8    113.19
SGP   -1 15/16   47.88
TROW  -3 3/32    37.78
XON   -  5/8     78.75
YHOO  -3        157.38


                  Day     Month  Year    History
        R-MAKER  -2.46%  -3.87%   7.75%  36.34%
        S&P:     -2.18%   0.20%   9.15%  35.02%
        NASDAQ:  -2.10%  -0.59%  15.29%  52.94%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
   6/23/98   34 Cisco Syst    58.41    115.44    97.63%
    2/3/98   48 Microsoft     39.13     76.88    96.44%
    5/1/98   55 Gap Inc.      34.37     62.63    82.21%
    2/3/98   22 Pfizer        82.30    113.19    37.53%
   2/13/98   44 Intel         42.34     58.00    37.00%
   2/17/99   16 Yahoo Inc.   126.31    157.38    24.59%
   5/26/98   18 AmExpress    104.07    120.75    16.03%
    2/6/98   56 T. Rowe Pr    33.67     37.78    12.20%
   8/21/98   44 Schering-P    47.99     47.88    -0.25%
   2/27/98   27 Coca-Cola     69.11     65.25    -5.58%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Eastman Ko    63.15     77.63    22.93%
   3/12/98   20 Exxon         64.34     78.75    22.41%
   3/12/98   17 General Mo    72.41     83.13    14.81%
   3/12/98   15 Chevron       83.34     94.44    13.31%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
   6/23/98   34 Cisco Syst  1985.95   3924.88  $1938.93
    2/3/98   48 Microsoft   1878.45   3690.00  $1811.55
    5/1/98   55 Gap Inc.    1890.33   3444.38  $1554.05
   2/13/98   44 Intel       1862.83   2552.00   $689.17
    2/3/98   22 Pfizer      1810.58   2490.13   $679.55
   2/17/99   16 Yahoo Inc.  2020.95   2518.00   $497.05
   5/26/98   18 AmExpress   1873.20   2173.50   $300.30
    2/6/98   56 T. Rowe Pr  1885.70   2115.75   $230.05
   8/21/98   44 Schering-P   2111.7   2106.50    -$5.20
   2/27/98   27 Coca-Cola   1865.89   1761.75  -$104.14

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Eastman Ko  1262.95   1552.50   $289.55
   3/12/98   20 Exxon       1286.70   1575.00   $288.30
   3/12/98   17 General Mo  1230.89   1413.13   $182.24
   3/12/98   15 Chevron     1250.14   1416.56   $166.42

                              CASH     $70.09
                             TOTAL  $32804.15

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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