What’s eating the IT services sector?

When Lou Gerstner arrived at IBM in 1993, the former McKinsey and Harvard Business School gun for hire had some breathtaking metaphors to describe the ailing tech giant: Big Blue was the late Roman Empire; the sick patient; the Titanic. In short, the bellwether for the IT industry looked like it was on its last legs. Gerstner’s solution? Get IBM into the IT services business.

Fast forward nearly two decades and the sector that revitalised one of the most storied tech firms in history is starting to look as decrepit as the pre-Gerstner IBM. The Goliaths of the IT services industry are taking a battering; once-mighty firms are being acquired by smaller rivals; the balance sheets of established players are today splattered in red ink; even the Indian offshorers are struggling to maintain their accustomed double-digit revenue growths.

So what has happened? Have IT chiefs gone off the idea of letting someone else handle the risk of running their IT? Hardly, but the IT services sector is an industry in turmoil.

Take EDS, the one-time poster child of the sector. When would-be presidential candidate Ross Perot founded the company in 1962, he had a vision of turning the provision of electronic data processing and computer hardware from a short-term business into a multi-year partnership.

One of EDS’s early customers – carmaker General Motors – was so enamoured with Perot’s business that it bought it lock stock and barrel.

The roller-coaster relationship between GM and EDS saw its ups and downs, but even after the 1996 divorce GM remained one of EDS’s biggest customers. The two global giants even seemed to shrug off EDS’s 2008 acquisition by HP – a $13.9 billion deal. But today, the relationship between the two stands as a damning indictment of the IT services industry as a whole.

Randy Mott, the former Wal-Mart and Dell CIO, is now heading up GM’s IT operations. Mott is a renowned stickler for numbers, and there are some numbers that make for uncomfortable reading over at HP/EDS. Before Mott, GM used to rely on services providers for 90% of its IT, with its own staff responsible for just 10%. Mott is intent on flipping those numbers on their head.

As part of his plan, Mott has taken an axe to GM’s agreement with HP, and set about reversing the transfer of labour. In early 2012, Mott unveiled plans to take some 3,000 staff once employed by HP/EDS and bring them back in-house. One of the companies that did so much to establish the idea of IT services in the 1980s seems to have lost the faith.

In August 2012, HP took a $10.9 billion hit, mostly writing down the value of its EDS acquisition. The firm that has bestrode the globe so confidently that it could order employees to be rescued from a hostile nation by helicopters and gun crews is now effectively worth just pocket change.

Next>>> Suppliers in the red

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And it’s not just GM that has fallen out of love with IT services. Across the entire sector, some of the largest suppliers have been enduring a torrid time.

Take IBM. For its third quarter of 2012 – the most recent results at the time of writing – revenue for its services division fell 5% year-on-year, from $15.2 billion in 2011 to $14.5 billion in 2012.

Given how emblematic IBM is for the IT services sector, such disappointing results cannot be lightly dismissed. But the sense of pandemonium is only exacerbated by the strife elsewhere.

In summer 2012, British provider Logica put an end to years of missed profit targets, rounds of job cuts and the sense of inertia that has gripped the company ever since its 2002 merger with CMG, and agreed to be acquired. The most eye-catching detail of the deal, however, was who it sold to – Canadian rival CGI, whose annual revenues were nearly half of those of its target.

The acquisition also prompted more bad news for Logica, with long-term partner BAE Systems canning a six-year HR deal as a result of Logica being acquired. And while the deal has propelled CGI into the limelight, it also underscores the difficulties that are facing IT services providers.

Others, such as CSC, have endured similar tales of woe. The firm has been bleeding red ink – in large part thanks to its involvement in the disastrous £12 billion NHS National Programme for IT. The fallout from that failure has seen its share price tumble and prompted some very uncharacteristically frank language from its chief executive, when delivering financial results.

In May 2012, company CEO Mike Lawrie said CSC’s results for the quarter ending March 2012 were “very poor” – a moment of rare candour compared with the usual sugar- coated platitudes that accompany bad news. “The company is executing well below an acceptable level,” Lawrie added.

That NHS deal has done much to poison the IT services waterhole in the UK, not just for CSC but for every provider. The waste of £12 billion of taxpayers’ money on a contract that has done little in the way of delivering 21st century systems for the health service has soured public opinion on big IT services deals, and it has helped harden the government’s stance on IT services.

“Since the coalition came to power, they’ve been ruthless on contract costs,” says Anthony Miller, managing partner at market watcher TechMarketView. “They recently got all the suppliers in again and asked them to take another haircut. But there’s only so many haircuts suppliers can take; in the end, if they cannot make money, they won’t bid for the contracts.”

Are organisations getting so little value from their IT services deals that they look anew at in-house provision?

Certainly, on the face of some readings, the IT services industry looks to be in fragile health, says Ovum analyst Ed Thomas. But it’s wrong to read too much into financial reports. “The way deals are structured, revenue for the contracts isn’t recognised until later in the deal,” he says.

A better way to check the health of the services industry is to look at the number of deals signed in proceeding quarters – this acts as a good predictor of the revenues that suppliers are likely to report down the line, says Thomas.

It’s fair to say that IT services providers will have been popping the champagne corks with less frequency of late. But while the number of deals, and particularly the value of those deals, may not have been matching their historic highs, “it’s still a reasonably healthy market,” says Thomas.

According to Ovum, there were typically only a handful of IT services deals in excess of $1 million signed each month in 2011; that number has shifted up in 2012, although the total value of the contracts has stagnated. The key to understanding what is happening in the IT services market is simply to understand what is happening in the wider economy, says TechMarketView’s Miller.

The financial services industry is still buckled by the weight of the credit crunch, and the UK’s high street banks have also been hammered by charges relating to mis-sold payment protection: these are not firms that have money to throw around like in the old days. And that means that the big projects are put on the back burner; what money there is to spend on IT gets funnelled to where it is most needed.

“That’s not to say they won’t spend on IT services, but they are cautious,” says Miller. There’s a similar tale in the public sector. Amid times of austerity, there is still money being spent on IT services, but every penny is watched very closely.

“The public sector and the financial services sector were historically two of the biggest spenders on IT services. Without those two sectors spending, of course the services providers are finding it tough. But the pain won’t last for ever,” says Miller. Nor should the fate of some well-known suppliers be taken as indicative of a sector- wide malaise, says Ovum’s Tom Reuner. “When you look at a write-down of the size that HP has made with EDS, you have to look at the management.”

Logica, meanwhile, was acquired by a company that could afford it. The same thing happens to publicly traded companies all the time.

At some point down the line, the global economy will pick up, and governments – including the UK’s –will loosen the purse strings. So will the IT services industry suddenly be renewed afresh?

As it happens, the plates of the IT services industry have been shifting, as there’s no simple way to put the old world back together again. The rise of the offshore services providers began the process, as skilled workforces in India, China, Brazil and elsewhere meant their IT services firms could match Western rivals on capabilities and beat them hands down on price.

Next>>> Disrupting the old order

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The IT services world, as created by the likes of GM and EDS back in the 1980s, was predicated on the economies of scale that could be achieved by providing data centre and desktop services, networking and infrastructure services, systems integration and the like.

Firstly, Indian firms such as Tata Consulting Services, Wipro, Infosys and HCL have shifted the balance. The fact that these firms are able to offer lower unit costs has intensified the need for Western rivals to scale, and build their own offshore muscle.

But while the suppliers’ business model has always emphasised the need for scale, the buyer-side trend has been to head in the other direction, says Ovum’s Reuner. Where once IT chiefs looked to get the biggest bang for their bucks via so-called mega-deals – where multi-year contracts were awarded to a supplier capable of delivering a soup-to- nuts IT service –in today’s risk-averse climate caution has become the watchword.

“We’ve seen the mega-deal being broken up, replaced by shorter deals, where multiple parties are expected to deliver different aspects,” he adds.

Instead of driving out cost through big contracts, firms are looking to competition to deliver better value. This splintering of services deals has further weakened suppliers built for scale. Smaller competitors can hoover up chunks of these multi- sourced deals on their own, rather than being brought in as subcontractors.

Furthermore, it has encouraged some on the margins of the IT services industry to extend their own capabilities.

G4S, a supplier more typically associated with the provision of security guards – or not, in the case of the London Olympics – has quietly bolstered its technology division, winning contracts such as the deployment of a new smartcard system for students at Newcastle University that a few years back it may not have gone for.

Others, such as Serco, have shown that an IT services provider need not be all about global scale, and that it’s possible to run refuse collection and city bike services alongside provision of public sector IT.

This combination of smaller deal sizes and a spending freeze in the public sector and financial services has hamstrung UK IT services suppliers of late, says Reuner. But the real challenge they face in the long run is that buyers are expecting suppliers to take on more of the risk associated with the deal, he adds. That puts suppliers in an unenviable position: additional risk has to be paid for by somebody, and if the buyers are unwilling to pay more, suppliers will have to offset the costs associated with additional risk by cutting their operating costs further.

There is a school of thought that suggests some of these cost savings can be achieved via cloud computing. To some, the cloud represents the next step in outsourcing: shifting your IT needs to a third party that can deliver huge economies of scale.

But not everyone is convinced. The UK government has certainly got the cloud bug, with its G-Cloud framework touted as the best way to procure public sector IT. But most G-Cloud contracts have gone to Huddle, with nearly nine out of ten contracts awarded since the framework’s inception going to the London- based collaboration software maker.

That’s symptomatic of the problem with cloud computing, says Miller. “If you replace the term ‘cloud’ with the words ‘bureau services’ you get a much clearer idea of its potential. Organisations will sign up for vanilla services, such as payroll, where it doesn’t matter if they use the same bureau service as a competitor. But they won’t do it for important stuff.”

As a result, businesses will be faced with a choice: find models of service delivery that offer suppliers an acceptable level of risk or accept that IT services are better managed in-house. Suppliers, meanwhile, are left pondering whether they need to acquire or be acquired in order to create further scale, and whether there’s a limit on how much of a haircut they can take.

The answers will, of course, vary from firm to firm and from supplier to supplier. And while the IT services industry is not in terminal decline, it can expect the turmoil to continue for some time yet.

Henry Catchpole

Henry Catchpole runs Inform Direct, a company records management software company which simplifies the process of dealing with Companies House. The business was set up in 2013.

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