Bid to rattle the windows at Microsoft

David Usborne reports from New York on what IBM hopes to gain from taking over Lotus

JIM MANZI, the chief executive of Lotus, received a fateful early- morning telephone call last Monday. On the line was Louis Gerstner, his counterpart at IBM, who said he wanted to warn Mr Manzi of what he was about to announce to the world: that he was going after Lotus with a $3.3bn (pounds 2bn) unsolicited bid. Mr Manzi, according to Lotus insiders, was "emotionally devastated" by the news.

His reaction was understandable. He was jealously protective of the independence of Lotus, the number three software company famous for its ubiquitous but ageing 1-2-3 spreadsheet programme and more recently for Notes, which allows groups of PC operators at different locations to work on the same material. And like everyone else, Mr Manzi was stunned that IBM was actually doing it. Big Blue, as the world's biggest computer concern is known, had never attempted a hostile takeover in its 70-year existence.

There are a multitude of reasons, however, why Mr Manzi must have quickly understood why resisting the bid was likely to be pointless and even perverse. By Tuesday night, he and Mr Gerstner were dining secretly together at a discreet midtown Manhattan restaurant to discuss making peace, while executives from both companies huddled on each of the next three days to ponder the implications of a merger. While, under US law, Lotus has until tomorrow week to respond to the bid, most analysts expect it to capitulate much sooner.

First, there is the question of price. IBM is offering a lip-smacking $60 a share for Lotus, representing a premium of more than 100 per cent on the share price shortly before the bid. To seal the marriage, IBM is rumoured to be ready to offer more, perhaps $65. Lotus's first instinct was to seek out a white knight, with the help of Wall Street advisers Lazard Freres, to top the IBM bid. But while some names surfaced, notably Oracle and also AT&T, with which Lotus already has an alliance, there was little expectation that either would have the cash or motivation to outbid Mr Gerstner. Any attempt simply to block IBM's advance would hardly endear Mr Manzi to his institutional shareholders, who hold more than 80 per cent of the Lotus stock.

Beyond the transaction itself, there is the deal's compelling logic. Mr Manzi might start by taking an honest look at Lotus itself. Once the dominant software player, the company has been reporting declining profits for the past two years, including an 18 per cent fall-off in the first quarter this year. Revenue from the 1-2-3 spreadsheet is slipping fast against the competition. Even the future of Notes is clouded by a lack of cash to sell and develop it. With IBM will come tides of money, not to mention the ineffable Big Blue sales force. In a letter to Mr Manzi, Mr Gerstner wrote last week: "This is truly a win/win opportunity for IBM and Lotus shareholders, employees and customers. With IBM's global marketing and sales capability, we can rapidly grow Notes' user base and vastly increase its sales potential."

Among financial analysts, there remains some scepticism about the benefits of the deal for IBM. Though the company says it has the required $3.3bn immediately available from a cash reserve of $10.5bn, how quickly it will earn a decent return on that from Lotus is open to question. But Mr Gerstner is not worried about such short-term financial niceties. His concern is with what he calls the onset of phase three of the computer revolution, and where IBM will fit into it. What interests him above all is how IBM can recover ground lost to the third man in this drama: Bill Gates of Microsoft.

While IBM was the great force in phase one of the industry, with its pioneering of mainframe computers, it slipped up badly in phase two with the introduction of desktop PCs, notably by ceding leadership in the development of PC software to Microsoft. (In 1981, IBM contracted to Microsoft to make the software for its PCs, a choice it has come to regret.) Hard as IBM has tried to push its OS/2 PC operating system, it has made barely a dent in the Windows system produced by Microsoft. While about 9 million computers in the world now use OS/2, no fewer than 60 million are using Windows.

But now for phase three when computers, rather than being isolated workstations for single users, are becoming tools of mass communication. Even the humblest of PC users at home in their parlours are discovering the change as they access all the data that is available on services such as CompuServe and Prodigy, and venture further on to the Internet.

Lotus offers IBM a fabulous platform in this new world with its Notes programme, which allows users to have as many of its employees as needed working on the same data at once, with each operator watching what the others are doing. These workers can be at adjacent desks or at different ends of the planet. Notes is already the dominant product in this so- called "groupware" category, with General Motors and the US Central Intelligence Agency among its leading clients.

IBM's aim is to make Notes a standard for the world. If it succeeds, and analysts think it possible, it would help catapult IBM past Microsoft once more. Microsoft's own "groupware" programme, called "Exchange", has had a troubled history in development and is not due out until next year, when it will have a lot of catching up to do.

Competition issues could prove a hurdle for IBM. When Mr Gerstner revealed his hand on Monday, there was instant muttering about anti-trust problems. IBM itself instantly filed a formal application to the US Justice Department asking for anti-trust clearance. It has been only three weeks, after all, since Microsoft was forced to abandon its $2bn takeover of the Intuit Corporation, the lead developer of home-banking software, because of federal government objections. And on Friday, news emerged of another possible Justice Department investigation into Microsoft's plan to integrate a new on-line service to compete with the likes of CompuServe in its updated version of Windows, Windows 95, due to be launched later this year.

But IBM has one advantage on the anti-trust issue: it is not Microsoft. Though IBM's proposed takeover of Lotus would represent the biggest merger ever in the industry, and may spark an avalanche of additional mergers and acquisitions in the sector, it is likely to hold some appeal to the regulators. Its principal effect will be to generate some serious competition for Microsoft once more.

It is the ever-tightening stranglehold of Mr Gates on the software sector that preoccupies regulators most. The New York Times said in an editorial last week that the deal could be good news for anyone who might enjoy the "prospect of an entertaining battle for primacy in the world's most important new business".

There is one final thing that might be leading Mr Manzi to bury his wounded pride. He owns 1.1 million Lotus shares. That is 1.1 million multiplied by $65, maybe. He is a bright guy: he has probably worked out the answer already.

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