Aging Tech Dogs Seek New Tricks

Hardware businesses are pushing more than ever for products beyond the low-margin box.
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EMC's

(EMC)

purchase of software outfit Legato offers one more example of the reinvent-yourself theme reverberating through techland. With the once high-and-mighty PC now looking a lot more humble --

retailing at the sub-$500 mark -- the big-name companies that piggybacked to fame on boxes are trying to make inroads into more lucrative stuff.

Software is the most appealing route for companies bent on diversifying, and no wonder, with its fat margins. Case in point: Last year, Big Blue's software division claimed a gross profit margin of 84.4%, compared to a relatively low 27.1% margin for hardware.

It's no surprise that hardware makers have made a spate of software acquisitions over the past six months or so -- witness EMC's recent purchase of a storage-manager product from

BMC

(BMC)

,

Sun's

(SUNW) - Get Report

acquisition of Pixo, and, on a much bigger scale,

IBM's

(IBM) - Get Report

purchase of

Rational Software.

Rush to Serve

But boxmakers also have made a tremendous push into services -- so much so that the industry has started to see some of the same creeping

commoditizing pressures that have afflicted hardware.

Still, exhausted by relentless battles for hardware market share, big boxmakers have clearly come to regard the two-fold combination of software and services as the wave of the future. IBM chief Sam Palmisano has predicted that by 2005, more than two-thirds of industry profits will come from services and software, up from 42% in 2000, according to a

Forbes

report.

IBM, of course, elicits knee-jerk fawning for its timely makeover into a services shop. Around the time the hardware economy was hitting the skids, Big Blue was watching its share of services revenue surge north of the 50% mark. By last year, services and software together accounted for 61% of total revenue. By contrast, the hardware division chipped in a mere 34% of 2002 revenue, down from 41% in 2000.

Further strengthening its services and software portfolio, IBM has made discriminating buys over the past year, plucking up consulting shop

PricewaterhouseCoopers

for $3.5 billion and Rational for $2.1 billion.

Rumors occasionally circulate that

H-P

(HPQ) - Get Report

too will bulk up its services and software business with an acquisition. Up to this point, CEO Carly Fiorina has taken pains to quash them, though with the Compaq merger now largely completed, the notion is perhaps becoming more conceivable.

Still, H-P seems far more content to be known as a hardware shop than IBM, pitching itself as the go-to place for all kinds of tech (in late '90s parlance, an "end-to-end solutions provider"). To some degree it may be making the best of a tough lot, with IBM having left it far behind on the service and software fronts.

On the other hand, in a strategic sense H-P sees its success in both areas as being inextricably linked to that of its hardware. In a May interview, Chief Marketing Officer Mike Winkler told TSC, "Software is embedded in every aspect of the business as opposed to being a discrete standalone entity. We like to think of it as part and parcel of all elements of hardware, but it is collectively growing."

H-P doesn't explicitly break out results for its overall software line, but ays its OpenView management software grew 9% over last year's levels in the second quarter. The chief of its software division has said the company pulls in more than $1 billion in revenue, making it the fifth-largest software outfit in the world. At that rate, H-P would draw just under 2% of sales from software.

Services still contribute a relatively paltry 16% of revenue, though H-P has lately scored some

high-profile services signings.

Dell

(DELL) - Get Report

has been diversifying, too -- though in its case, that's mostly meant trying to sell different flavors of commodities. Even its young and fast-growing services arm exists only to help sell more of the company's computers (if it conveniently happens to pull down prices, furthering the trend toward commoditization in services and thus hurting rivals, all the better).

Though it's closely identified with the PCs that made it famous, Dell has branched into servers, storage and networking switches, as well as printers and PDAs. Its push into bargain-priced servers was an act of fortuitous timing: In 2002, Dell managed to squeeze out 6% sales growth at a time IBM, Sun and Fujitsu all saw their server revenues shrink, according to IDC.

But while the forays into new hardware arenas clearly have unsettled rivals, Dell views software and peripherals as the fastest grower down the road, likely to become the second-largest source of sales after PCs. It's relying on this arena to help meet its goal of doubling revenues to $60 billion in five years.

While PCs currently make up the bulk of revenue, accounting for 81% of sales in 2002, CEO Michael Dell has said he'd like computers to become a smaller portion of the mix, contributing around half of total revenues going forward.

On the hardware side, perennial underling

Gateway

(GTW)

has been trying to flesh out its consumer electronics business by introducing its own line of goods, aiming to roll out dozens of products under its own brand by the end of this year. The company told analysts that PCs should account for around 60% of revenue by 2005, down from over 80% last year.

It's too early to gauge the strategy's success, and worth noting that the latest makeover marks only the most recent entry in a string of failed restructuring projects. For the past two years, non-PC or "beyond-the-box" sales (including consumer gadgets, software, peripherals, and warranties) have stayed flat at 17% of net revenue.

Finally, Sun has been fleshing out its portfolio with acquisitions. Just last month it announced the purchase of Pixo, a private company with Java-based server software that can be used in conjunction with mobile devices. The deal was part of Sun's plan to give a boost to its Java software. Last fall, Sun bought Pirus Networks, another private company. Its storage technology fits with Sun's strategy to make it easier for customers to use storage more efficiently.

The retrenching may seem slow at times, but at least change is under way at the leading boxmakers. That should offer some consolation for investors fed up with hearing about PC woes.