An Info-Tech Haven Called Outsourcing

Slashed IT budgets, the bane of most technology companies, have produced strong gains for the likes of IBM and EDS

The people at Computer Sciences Corp. won't soon forget Mar. 16, 2001. On that day, the technology-services giant missed its first-quarter profit targets by 60%, citing a massive drop-off in demand. That prompted a flurry of analyst downgrades and a sell-off of CSC's shares that wiped out $3.6 billion of market value in one day. But when CSC (CSC ) faced Wall Street analysts in a conference call three days later, it could point to one line of business that remained strong: outsourcing.

Ten months later, information-technology (IT) outsourcers are still surging ahead of the sluggish tech pack. Services revenue is expected to grow 9%, to $603 billion in 2002, after rising 7% last year, according to market tracker Gartner Dataquest. And outsourcing, which accounts for about half of that total, will do best, expanding 12%.

Why? Economic uncertainty is keeping corporate eyes trained on cutting costs, especially technology costs, which ballooned during the fat years. So companies are keeping payrolls lean and capital spending in check. They're getting more work done by outsourcing specific projects. Earnings at the industry's three biggest outsourcing companies -- IBM (IBM ), EDS (EDS ), and CSC -- will grow an average of 27% this year, according to Thompson Financial/First Call.


  Small wonder outsourcers are the envy of woebegone hardware and software makers these days. Instead of missing profit targets, EDS beat them by a penny per share in the quarter ended Sept. 30, while expanding revenue 16%. In the same period, IBM saw outsourcing grow 13%, to $3.5 billion -- even as its computer sales shrank by 21%. IBM finished 2001 with services revenue up 5%, compared to a 12% decline for hardware sales. Even CSC expanded European revenue 25% in the quarter and is now facing a new challenge: filling 1,000 open jobs.

For Solutia, a St. Louis-based specialty chemicals company spun out of Monsanto in 1998, the choice was simple: Spend big money to set up its own computer systems or outsource the task to EDS. Solutia farmed it out. This fall, beset by weak demand, it extended its contract when EDS promised to boost annual savings an additional 15% to 20%. Says Solutia CIO Johnnie M. Foster: "I haven't had to invest a lot of capital. Someone else has."

After September 11, customers looking to quickly strengthen security and backups of important data are asking for help, spurring a tripling of inquiries at EDS. Government agencies with their minds on security are turning to outsourcers, too. "It's a terrific time to be in the business we're in," says Jeff Rich, CEO of Affiliated Computer Services (ACS ), which on Oct. 25 won a $74 million contract to manage data on arrivals and departures of foreign visitors for the Immigration & Naturalization Service. Rival CSC, meanwhile, will help the Defense Dept. improve coordination between military branches and train MPs to fight cybercrime.


  All of this might not be happening if it weren't for solid execution by outsourcers. After several years of EDS disappointing investors, CEO Richard Brown whipped the company's cost structure into shape, eliminating $2 billion in expenses. That, coupled with better pricing of contracts, helped to boost third-quarter operating margins to 11.2%, from 9.7% a year ago. And Brown isn't letting up: In October, he slashed maximum severance pay from 26 weeks to 4 just before laying off employees. The move prompted a lawsuit from one, but EDS insists morale is fine.

After its March madness, CSC also restructured, streamlining operations and eliminating 900 jobs. Its margin rose to 5% in the quarter ended Sept. 30, up from less than 4% in the two prior quarters. That's still razor-thin, but it's making up for steep declines in CSC's more profitable businesses. Now, with a $2 billion contract from the National Security Agency, CSC is staffing up again.

The industry isn't completely immune to the economy's ills. Facing massive overcapacity, technology consulting and systems-integration units are performing dismally. Clients are faltering, too, causing delays in payments and new contracts. And while the market has bid up shares, many investors worry they're overvalued.


  Short-sellers have been circling EDS since cash flow came in weaker than expected in the third quarter after falling $600 million the first half of 2001. The company says it's a victim of its own success: The billions in contracts it has signed recently require EDS to make huge capital outlays in their early years. But, declares Brown: "We are very well insulated. We do well in times like this."

If they can keep it up, IT outsourcers might end up overcoming investor skepticism about their long-term prospects, analysts say. "They will be viewed as safe havens," predicts Lehman Bros. analyst Karl Keirstead, who on Jan. 17 upgraded EDS to a strong buy from a buy, and raised his price target to $85 a share, from $80. At least some in techdom could be beating the odds.

By Andrew Park in Dallas

Edited by Beth Belton

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