(FORTUNE Magazine) – The metamorphosis of CEO Lou Gerstner's IBM seems to be moving beyond the larval stage. In January, Gerstner further streamlined the organization, filling important new positions with respected career IBMers. And the company offered to buy back $1.1 billion of interest-bearing preferred stock issued during its 1993 cash crisis. Having lots of spending money--some $11 billion in cash--buys Gerstner more time to shoulder this $63-billion-a-year enterprise from an Eisenhower-era provider of mainframes toward today's PC software-and-services paradigm.

The financial turnaround is spectacular. According to CFO Jerome York, a Gerstner hire from Chrysler, IBM forecast negative cash flow from operations of $3 billion in 1993. Instead, by hacking away at a bloated cost structure, it came out $800 million to the good and added $3.1 billion in 1994's first three quarters. IBM has reduced its core debt by 55% in the past year. Fourth-quarter 1994 results, scheduled for a January 23 release, were expected to shine.

The end of massive layoffs helps. Between 1986 and 1994, IBM wrote off a staggering $28 billion, nearly two-thirds of which went to severance pay for 180,000 axed employees.

The bad news is that IBM's most successful businesses are dated. While sales of mainframes unexpectedly are flying--consulting firm Annex Research expects big iron, one of IBM's most profitable businesses, to contribute nearly $600 million to the 1994 bottom line--the boom times can't last. IBM is much weaker in today's winners, PCs and software. Though it remains the world's biggest seller of software, with $11 billion of sales, those revenues crept ahead 2% in the first three quarters of 1994, while Microsoft's jumped 27%. With the exception of the estimable OS/2 operating system, which the company is only now selling with vigor, IBM's software is primarily for mainframe users.

That's where the reorganization comes in. Gerstner has made a number of key moves, including naming a new global head of sales and service. But the most important is consolidating most IBM software under John Thompson, who was running some of the most profitable hardware lines. Robert Djurdjevic, president of Annex, warns that Thompson's considerable marketing skills may not count for much until he has products customers want. And creating them from scratch could take too long. Says Djurdjevic: "If Thompson does his job right, he will invest in leading-edge software providers." IBM has been mentioned as a possible buyer of Apple Computer and Lotus Development, but the acquisitions needn't be that big. In the months ahead, expect to see Gerstner spend some of IBM's cash buying a few cool software companies. Stay tuned: the pupa within this cocoon might fly after all.

- Stratford Sherman