Last year was bad news for IT service providers: IT outsourcing (ITO) hit a wall and stopped growing.
Why? A confluence of factors gave ITO service providers a body blow. First, they are still suffering from the aftershocks of the dotcom bubble. Things were rosy when companies raced to outsource because of the scarcity of resources. Today, outsourcing is recession driven. The primary reason companies outsource IT in this economic environment is to save money.
Couple this focus on price with the increased competition for the ITO dollar. New market entrants from India are putting pressure on prices as buyers embrace the clear cost savings produced by labor arbitrage.
At the same time, new firms with unquestioned credibility and market permission have entered the marketplace. The HP-Compaq merger and IBM’s purchase of PricewaterhouseCoopers’s (PwC) outsourcing unit created two potentially powerful combinations. In addition, the market felt the effects of Cap Gemini’s purchase of Ernst & Young this year, even though the actual merger took place in 1999.
New entrants and a buyer’s increased focus on price have had only one result for ITO service providers: an increasing pressure on prices. Tier one providers struggled because of this price squeeze.
Second, September 11 and the potential war with Iraq created indecision in the market. Last year companies were preoccupied with continuity planning and worked to avert risk. The market psychology, worried about terrorism and war, was not ready to tackle the hard questions that bubble up in an outsourcing initiative.
Fortunately, this great wall of indecision began to crumble in June.
Weathering the Equity Valuation Crisis
It was painful to watch the downward slide of the stock prices of the major IT service providers. Many watched their prices tumble from the high 20’s into single digits. The much publicized lay offs didn’t help.
Much of the slide was simply reflecting the overall bear market. However, many buyers were worried about the significant price drop; could the service providers afford to make significant capital investments, they wondered. The perception of problems kept many buyers from inking mega deals.
In fact, many ITO service providers balked at deals where they had to make huge cash outlays up front, delaying profitability to later years. Tier 1 service providers are clearly not willing to make big bets on infrastructure. I believe that’s one reason why the Procter & Gamble outsourcing endeavor never happened.
Consulting Demand Off
The PwC and Ernst & Young purchases resulted in a dramatic devaluation of those assets. Overcapacity in enterprise resource planning (ERP) firms caused the same result. The outcome: a significant reduction in the market for professional consulting services. Buyers, this is a great time to buy IT consulting!
In sum, 2002 was a year of transition. Buyers shifted their mentality and changed the nature of their outsourcing endeavors. Many delayed outsourcing plans until they are sure of the direction they want to take and the financial stability of their outsourcers. ITO moved from a growth sector into a mature business.
Predictions for 2003
Unfortunately, I think the price competition will continue this year, because the overcapacity hasn’t worked itself through the system yet. In addition, the availability of offshore workers, coupled with their new credibility, has firmly established offshore service providers as a viable, indeed, critical component of an outsourcing offering today.
One new trend I see is some service providers are now willing to assume more risk for the end product. Savvy buyers are demanding their outsourcers assume more of the business risk of outsourcing. Service providers are agreeing because they will share in the increased equity, if it develops. I’m seeing deals where the service provider structures and prices the transaction to own the end result.
Finally, I see the integration of ITO and BPO. Like the country and western song, they are “meeting in the middle.” Combining IT in a BPO offering helps service providers create new value in the outsourcing transaction. And that’s just what buyers need in these tough economic times.
Lessons from the Outsourcing Journal:
- ITO service providers are under price pressure because of increased competition from offshore providers and new potential powerhouses created by purchases.
- There’s overcapacity in the outsourcing consulting space.
- Buyers have shifted their ITO focus from dealing with scarce resources in a boom time to tunnel vision about price.
- ITO and BPO are meeting in the middle to create one robust offering.
- Service providers are pricing deals to take on more risk and become responsible for the end product.