IT services group Admiral delivered a profit warning this summer. With year 2000 looming – and a freeze in spending planned by virtually all IT departments – it said its profits were not going to grow. (see Computing 13 May)
Given that Admiral typically sees 30% plus growth in annual profit, and 20% growth in annual turnover, the stock markets reacted nervously. The company’s share price plunged – and hasn’t recovered. Other services houses were also hit by the City’s loss of confidence.
The spending freeze over year 2000 is likely to affect more services firms, and analysts predict further profit warnings. Companies particularly at risk are those outside the European top 10 suppliers in terms of size and performance
The outlook for users is also uncertain. As services houses underperform they become vulnerable to acquisition, particularly from foreign competitors. Their strategies can become fraught, and more subject to sudden changes in direction.
The outlook for services companies seems bleak. They are facing a slowdown in new business after years of unprecedented growth – from 21% to 10% per year, says analyst Richard Holway in this year’s Holway Report.
Pain for mid sized players
Industry giants are already taking action. EDS, for example, has begun a reorganisation to win new business. However, it is the middle tier of services suppliers, such as Admiral, which is being hit the hardest by the spending slowdown.
Brokerage house Granville wrote to investors last week warning of ‘poor performances, missed estimates and stock profit warnings’ across the IT sector.
It is difficult to predict who will suffer the most, because this depends on individual customers, says Granville. However, the company said the market has underestimated the ‘potential loss of nerve’ which will occur in the fourth quarter.
Antony Miller, an analyst at Holway’s firm, predicts that more companies will be affected in coming months. “This is just the beginning,” he says. “So far, we’ve had 20 companies deliver profit warnings. There are going to be more.”
The key point will occur at the beginning of September, when services houses Sema Group and CMG declare interim results. Ian Spence, an analyst at investment bank West LB Panmure, predicts the market will be unsettled if the companies perform poorly, and that smaller players will be more vulnerable to acquisition.
“If their order books are weak, we could see a bloodbath in the markets because the valuations of these companies are very high,” he warns.
The main threat will come from abroad, where there are plenty of bigger rivals waiting to pounce. Debis Systemhaus, Germany’s top services house, owned by car giant DaimlerChrysler, is eyeing UK services suppliers.
The company’s UK arm has 95 staff and an annual turnover of £11 million. However, its annual turnover worldwide is £4.4 billion and it holds a multi million dollar war chest.
Debis was in the running to buy Computer Sciences (CSC) for about $10 billion (£6.25 billion) last year, said one company source, who wished to remain anonymous. The company also approached BT to buy the telco’s systems integration arm, Syntegra.
Mike Alford, managing director at Debis UK, says the unstable nature of the UK market could mean that those companies which underperform will be vulnerable to attacks. “Share prices have fallen by as much as a half in some companies, and they are falling still,” he says. “It’s going to be a very interesting winter. Under such circumstances, those with deep pockets will win.”
Is it time for small firms to strike deals with larger players?
EDS and IBM, for example, have record order books. However, size is no cushion against financial difficulties, and EDS is in the middle of painful restructuring following two years of poor financial performance. This includes job losses in the UK.
However, many smaller companies will not want to deal with larger outsourcers. Large suppliers often struggle to retain the focus possessed by their smaller counterparts, and many customers will prefer the level of service and price they get from smaller suppliers.
Richard Sykes, formerly chief information officer at chemicals giant ICI and now chairman of consultancy Morgan Chambers, signed a five-year £75 million outsourcing deal with Philips owned Origin while working at ICI. The deal gave Origin, a little known Dutch supplier, a firm foothold in the UK.
Sykes says Origin won the contract ahead of EDS because it was hungrier and more focused. Big companies do not know what resources they have, so they pitch an artificially high price, he says.
“EDS had a typical big company problem,’ he adds.
Large companies are essentially in a league of their own, supplying global deals or dealing with very large clients because their operations are geared to scale.
When BP tendered a global desktop outsourcing deal to rationalise its cluster of desktop services contracts last year, it awarded EDS the contract. EDS and IBM Global Services may not be interested or able to scale down their operations or their prices to suit smaller customers.
Niche knowledge to compete
Niche knowledge has brought considerable success to smaller services firms. One of the UK’s fastest growing services suppliers is CSL, the outsourcing arm of the UK operation of accountant Deloitte & Touche. CSL’s profit grew dramatically last year from £45.6 million to £83.3 million. “We’ve had to be very disciplined and focused,” says CSL solutions director Alan Titheridge.
CSL handles public sector accountancy business, revenues and benefits for local authorities (where it has the number one market share over EDS), and the move to resource accounting in central government. These involve heavy use of IT.
The company is beginning to grow beyond the public sector into areas such as insurance. It is also taking advantage of the emerging trend of outsourcing business processes rather than technology-based outsourcing.
Richard Holway predicts that business process outsourcing will become one of the fastest growing sectors of the market. He estimates that it will grow at an average rate of 60 per cent per year between 1999 and 2002, compared with 14 per cent for the wider outsourcing market.
Services house FI Group also touts the advantages of focusing on one area. It concentrates on application management rather than targeting given vertical markets. However, the company has now reached the limits of the application management market, and has acquired Indian offshore development house IIS Infotech and a consultancy called OSI.
Spence, at investment bank West LB Panmure, says the next few months will be very tight for suppliers because contract order books are shortening and dropping in value. However, middle-tier players are bullish about their long-term future. The FI Group turned over £228.4 million last year – a rise of 41% from 1997.
“Year 2000 is hardly a new phenomenon,” says Trish Gardom, FI Group board member and group marketing director.
“Dealing with it is incorporated into our strategy. Spending may be cautious for a while, but there’s a lot of pent up demand out there.”
Mark Coughlan, European chief information officer at JP Morgan, agrees. He says considerable demand has built up during the period of upgrades for year 2000 and economic and monetary union upgrades. Pressures to deliver on ecommerce will grow, not lessen, he says.
Richard Sykes, chairman of consultancy at Morgan Chambers, says new growth will be driven by customers’ demand. Companies no longer want hardware or software delivered as commodities, they want consultancy, integration and value added services. As the market slows down, suppliers will be more hungry to cut deals along these lines, and at prices that the customer really wants.
“As technology matures, what was a product will be provided as a service. Two or three years ago, you could get SAP only as a product. Within the next year, you’ll be able to get it as a service,” says Sykes.
Niche companies are likely to survive by playing on their skillsets, such as SAP. This includes the development of supply chain and customer relationship management systems.
Ebusiness to replace millennium business
However, small or niche companies should not be complacent. Spence warns that such services companies are likely to survive only if they adapt to changing customer needs, such as ecommerce services. He says this will explode once millennium compliance work, which has been creamed off by many and added to the industry’s record growth, is finished. Services companies reap up to 20% of their revenue from such offerings at present, but this will double by next year, he says.
“Ecommerce, in particular business to business ecommerce, will be a boom for the industry. It will be as big as the move to client/server earlier this decade,” Spence says.
Services firms that fail to adapt or those that supply more general services are likely to be snapped up by larger companies and foreign bidders simply because they will increase the regional presence of the larger players. “There’s an increased need for pan European companies able to offer global supply,” says Spence.
Today’s market is uncertain, but the long-term outlook is optimistic. Spence says a tightening of the situation in the fourth quarter will be very brief because of the strength of underlying demand and general brighter economic prospects. Opportunities for predators will not last long, he adds.
However, the question remains over what happens if future rates of growth fail to match the levels which the industry has enjoyed in recent years? Suppliers outside the European top 10 should be safe, however, as their business comes from customers who favour their particular focus and skills, instead of their size. All the IT director must do is find the supplier that is looking for him or her.
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