Outsourcing companies benefit from economic downturns, conventional wisdom suggests, as organisations look to cut their IT infrastructure overheads and create a more predictable cost structure.
So it is of little surprise to see outsourcing-centric services vendors such as EDS outperforming IT services companies such as Cap Gemini Ernst &Young (CGE&Y), where the emphasis is more on systems integration and consultancy.
While CGE&Y posted another set of falling revenue in the second quarter, EDS increased sales across the board. In its outsourcing unit – which accounts for two-thirds of total revenues – sales rose 8.5% to $3.65 billion. But business was also up in EDS’s consulting division, where revenues rose 3.2% to $1.52 billion.
The company’s aggressive move into product lifecycle management (PLM) software is another upbeat area. On paper, revenues increased by 52% to $228 million, but these were pumped up by the mid-2001 acquisition of Structural Dynamics Research Corporation (SDRC).
These results look impressive in a downturn, but there are doubts about the quality of those revenues. Revenues from General Motors, EDS’s biggest client are declining; US Airways, with which EDS has a $200 million annual contract, filed for Chapter 11 bankruptcy protection in August 2002; and WorldCom – with which the company has an 11-year, $6.4 billion outsourcing deal – did likewise in July 2002, forcing EDS to write off $101 million.
Some of the biggest costs for outsourcing services vendors come at the start of contracts – which become more profitable in subsequent years. If WorldCom were broken-up, EDS would be hit particularly hard as that contract has been running for just three years.
At the same time, analysts have suggested that EDS may have been over-aggressive in recent years – bidding too low and accepting too great a share of the risks in its eagerness to win big contracts. That may explain the very public withdrawal in July 2002 from a proposed decade-long, business process outsourcing (BPO) contract with Proctor &Gamble (P&G) worth $1 billion a year – a deal that would have seen EDS paying to take over business assets belonging to P&G. After lengthy negotiations, EDS’s CEO Dick Brown concluded that the price P&G was asking for these assets was simply too high.
In contrast, Paul Hermelin, CEO of CGE&Y, may wish he faced such dilemmas more often, after a half year in which revenue decline has accelerated. A significant part of that downturn stems from an acquisition that was considered a masterstroke at the time: the purchase in May 2000 of the consulting arm of accountants Ernst & Young for EU11.5 billion.
CGE&Y saw the acquisition as expanding its activities into higher margin consulting services as well as dramatically increasing its presence in the key North American market. However, the deal quickly lost its lustre as the economic downturn took hold and consultancy demand weakened. In February 2002, Hermelin warned investors that this year would be one of restructuring, following a small fall in revenues in 2001, a trend that has snowballed in 2002. Bookings fell away during the second quarter, as major projects were postponed or cancelled – particularly in the US. The company has responded with further staff reductions.
One bright spot for CGE&Y was an increase in outsourcing business thanks to major contracts with Canada’s Ontario Power Generation and energy company Hydro One. Outsourcing now accounts for 27% of the company’s revenues.