An Unseen Peril of Outsourcing

An offshore alliance seemed to answer a struggling outfit's prayers. Instead, the U.S. parent has been wound up and its intellectual crown jewels are in India

By David Gumpert

This is a story about two companies in two countries -- a story that may provide some idea of one of the unexpected directions the ongoing trend to overseas outsourcing could be taking. The first outfit is AM Communications, an American outfit, and the second, India-based NeST Group.

First, a little history. Late in the summer of 1998, a mutual contact hooked up Javad "Jay" Hassan, an Indian-born American who had worked for IBM and other outfits, with Alvin Hoffman, the largest shareholder of AM Communications (AM), a small, publicly-held company based in Quakertown, Pa., that developed and owned software used by cable-TV operators to monitor their systems. AM, which began in the mid-1970s installing lines for cable-TV systems, had seen its ups and downs -- and fiscal 1998 (ended March 31) was one of its down periods. Sales, which the previous year had been $16 million, came in at around $9 million, due to the loss of several key customers.

"The company was about broke at the time," recalls Hoffman, a stockbroker by profession, who invested what he estimates to have been around $8 million of his own money in AM Communications after becoming involved in 1987. By 1998, things were so grim he feared a distress sale or bankruptcy if he couldn't find a savior.

NEW GAME PLAN.

  That's when Hassan entered the picture, negotiating a deal in late 1998 to become CEO and assuming the voting rights for most of Hoffman's stock. The cost to Hassan for gaining control of an established public company? Nothing, according to SEC documents.

"He was a visionary," recalls Hoffman in explaining his willingness to turn over control to Hassan. That vision was to bring AM's costs down by outsourcing programming and other tasks to India while steering the company into high-margin services. Says Hoffman: "He was ahead of his time with outsourcing."

There also was another component to the deal. On the same day in November that Hassan became CEO and took over voting control, AM entered into a consulting agreement with "Network Systems & Technologies (NeST), an affiliate of Mr. Hassan, which is located in Trivandrum, India," according to documents AM filed with the SEC. In other words, Hassan would direct work to a company in which he had a stake and from which AM was to receive preferential rates.

That consulting agreement went into effect pronto, and by the end of the next month -- December, 1998 -- more than $200,000 of AM business had been sent to NeST. "He (Hassan) had this vision for a new kind of company, a virtual company, that would own a technology or customer base and outsource everything else," recalls Joe Rocci, at the time AM's vice-president of product technology. "Right from the beginning, the deal was that he [Hassan] would take AM's operating costs way down by taking everything, and I mean everything, to India," adds Rocci, who has since left the company. "In the course of two years, we had moved 50 to 60 engineering jobs and all of manufacturing, probably about 80 jobs, to India."

WELCOME PROFITS.

  In Hassan's view, outsourcing was the only way to save AM. "We needed $5 million worth of new R&D in software and hardware to turn the company around," he says. "No one was willing to give us $5 million. I said, 'Why not give the NeST people the business?'" He was convinced the $5 million worth of work could be done for $1 million by NeST.

For a while, it seemed as if AM and NeST were making out just fine. AM's revenues increased, and NeST's billings to AM increased as well. Hassan engineered a couple of acquisitions of service-related companies and AM's revenues headed up -- to $16 million in fiscal 2001 and $28.7 million in 2002. The outfit even made some money -- a bit over $1 million in 2001 and $700,000 in 2002.

Between the end of 1998 and the start of 2000, NeST billed more than $1.8 million of outsourcing charges to AM, for which it was paid in AM warrants convertible to stock -- an arrangement that reflected the American operation's weak financial position. Beginning in 2000, NeST began receiving cash for its outsourcing services -- collecting $10.1 million from AM between Apr. 1, 2000, and Mar. 30, 2002, for development and manufacturing services, according to documents AM filed with the SEC.

LABOR INTENSIVE.

  "The company was doing well," recalls Rocci. "We rebuilt it from the brink of bankruptcy." It seemed as if the outsourcing was doing what it was supposed to do: improve the profitability of software-products area, thus helping to finance the expansion into new services.

In retrospect, however, Rocci now attributes most of the gains to improved product sales. "There were productivity issues over there (in India)," he recalls. "Here, one guy might do the work of five or six in India." And there were cultural issues that presented major hurdles. "It was difficult to get one guy to run one project. They work in teams and it takes a minimum of two people to do anything. I remember I was over there once and I was walking by a metal-stamping press, and there were two people sitting shoulder-to-shoulder -- the whole mindset was to create jobs." Even so, Rocci notes that some administrative jobs couldn't be handled in India and were sent back to the home office.

Walt Wilszewski, vice-president of sales and marketing at AM, had the same feeling. "I felt we needed one-and-a-half times the Indian programmers to do the same amount of work as U.S. programmers," he says.

PICKING OVER THE WRECKAGE.

  Regardless of the role of outsourcing in AM's rising fortunes, during fiscal 2003, AM lost a major customer and, combined with serious cash-flow problems, "the bottom fell out" of the business, says Rocci. During the first nine months (the last period for which financial results were reported), losses nudged $2 million, and there was a mad scramble for cash. Banks extended a special $1.25 million loan over and above the existing credit line, Hoffman poured in about $1.4 million, and Hassan about $2 million. It was all to no avail. By June, Hassan had resigned as president and CEO to become chairman. Last August, with all other avenues of hope exhausted, AM sought protection from its creditors under Chapter 11 bankruptcy laws.

During the last three months of 2003, AM's assets were sold to repay the bankers. Two service companies AM had purchased were reacquired by their original owners. A third area -- the products area that represented the original core of AM's business -- was put up for sale. Hassan wanted NeST to acquire it, and the creditor's committee designated him the favorite, the "stalking horse," in bankruptcy lingo. His offer of $4.5 million to $5 million consisted primarily of a renegotiation of AM's bank's obligations and between $1 million and $1.5 million of cash, he says.

A competing group entered the bidding process at the end of 2003 -- a group of former AM employees that included Rocci and Wilczewski. Their offer of between $4.5 million and $5 million essentially matched what Hassan was offering, they say.

BRAIN DRAIN.

  Last December, however, as the former employees assembled at the courthouse to make their offer, the plan fell apart. "Our investor got spooked and walked out, based on what he heard about AM," says Rocci.

What upset the potential backer? In large part, it was the sense that not only were the manufacturing and development services based in India, but that the company's most important knowledge -- software and engineering savvy, not to mention its development expertise -- also had departed the U.S. Says Rocci: "All the knowledge about how to do things had moved over to India." The investor's withdrawal scuttled the former employees' proposed deal to acquire AM's products business did so because he saw that outsourcing had essentially stripped the concern of perhaps the most important asset of them all -- its knowledge.

The lesson of this story: We need to understand that, as we send jobs to foreign businesses, we also send critical knowledge about processes, procedures, and development. When business conditions change, a company can't just go to the other side of the world and reclaim those things. The new owners aren't likely to give them up.

David E. Gumpert is the author of Burn Your Business Plan: What Investors Really Want from Entrepreneurs and How to Really Start Your Own Business. Readers can e-mail him at david@davidgumpert.com

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