The Deal Drought
Like so many tech outsourcing deals, the transaction looked great on paper. On Mar. 28, 2001, IBM (IBM ) put out a press release trumpeting a five-year, $112 million deal to handle all the computing needs of NeTune Communications, a Culver City (Calif.) startup that digitizes the production process for movie and TV studios. NeTune turned over everything to IBM, from running its computers that transfer digital images at high speeds to providing round-the-clock support to its PCs.
No press release went out when NeTune renegotiated its contract less than a year later. Battered by the threat of an entertainment-industry strike, the September 11 attacks, and Hollywood's slow adoption of digital technology, NeTune cut back its business with IBM. Now, NeTune manages its own computers and uses IBM for just a few things, such as software maintenance. The value of the deal? "It's under $10 million," says Patrick Block, NeTune's chief technology officer.
NeTune isn't the only customer rethinking its needs. The sluggish economy is causing scores of companies to shrink their service deals or bring computer operations back in-house. Sprint (FON ), Nortel Networks (NT ), and Ames Department Stores are just a few that have recently reworked arrangements.
The problem is becoming so acute that IBM Global Services head Doug T. Elix voiced his concerns in an Apr. 22 e-mail to employees that was obtained by BusinessWeek: "Many of our existing customers have been restructuring their contracts with us to help bring their overall spending down, which offsets our ability to generate growth from new business," he wrote. Indeed, IBM's service revenues fell 3% in the first quarter, after a 1.4% drop in the fourth quarter--the first back-to-back drops for the group.
The sudden wave of contract restructuring has become the service industry's version of a nasty termite problem: a largely hidden force eating away at its foundation of sales growth and profit margins. TPI, which advises clients on outsourcing deals, says 30% to 35% of its business last year came from helping clients rework contracts, up from 15% to 20% before the tech downturn. For the service industry, contract rollbacks are just the latest blow. Players have been struggling for more than a year now to land new deals. Even when new contracts close, they are inked only after 6 to 18 months of grueling negotiations, vs. 3 to 6 months before the slump.
Tech-services companies may have more troubles ahead. Several of them appear to be in violation of financial regulations. The Securities & Exchange Commission requires companies to disclose the size and any material changes in their contract backlog in their annual 10-K filings. But a survey by BusinessWeek turned up few disclosures. In their most recent filings, Electronic Data Systems (EDS ), Computer Sciences (CSC ), and Accenture (ACN ) do not include their contract backlogs, even though some have disclosed the figure during their earnings calls and in press releases.
EDS Chairman Richard H. Brown, for example, bragged in the company's 2001 annual report that "our backlog was greater than four times current year revenue." The SEC says the regulation is designed to give investors more information, but it declined to comment on specific possible violations. EDS' Brown declined to comment on the SEC rule.
Service companies insist they are in compliance. Spokespeople for EDS, CSC, and Accenture say the rule applies only to products, not services, and pertains to "firm" orders. Contract backlogs, they argue, are never firm. But Lynn E. Turner, former chief accountant of the SEC and an accounting professor at Colorado State University, says SEC regulation S-K, Item 101, clearly requires companies to report product or services backlogs.
He also disputes the contention that service contracts are not firm. Companies often put out press releases with contract values, he says, and have to invest millions to get the deals up and running. "It is somewhat disingenuous to say in press releases that you have been awarded large contracts but claim for SEC filing purposes [that] those contracts have uncertainties in them," he says.
Industry leader IBM discloses backlog data in its financial filings. But the company may run afoul of the SEC rule anyway. The Elix e-mail expresses management's concern about contract restructurings, but IBM doesn't mention the issue in its 10-K. Says Turner: If companies "are not disclosing events or changes that are having a material effect on their operations, then they are subject to sanction by the SEC." Elix says IBM follows the SEC rules. He says Big Blue doesn't disclose contract renegotiations because "it's not part of the standard [information] we cover in our quarterly releases."
Not every services player is feeling the pain of shrinking contracts. Consider the roster of companies on BusinessWeek's Info Tech 100 list. There are 21 tech-services companies, up from eight last year. The new members are smaller outfits zeroing in on outsource opportunities in niche markets. It's not flashy work, but it's fast-growing and lucrative. First Data (FDC ) (No. 50), Affiliated Computer Services (ACS ) (No. 7), and Certegy (CEY ) (No. 26) are rising stars that handle a range of chores from payment processing to managing human resources. This year, Lehman Brothers Inc. expects Affiliated's revenues to grow 49%, to $3.07 billion, as it manages call centers and payroll and transaction-processing jobs for companies and the government.
The incumbents on our IT 100 list--giant contractors that provide a wide range of tech services--still dominate the business. However, unless they sign a lot of new deals before yearend, these titans are headed for even tougher times. The problem is that companies such as IBM (No. 21), EDS (No. 11), and Computer Sciences (No. 28) are finding that new business is taking longer to close. In the most recent quarter, Electronic Data Systems Corp. said it couldn't close $126 million, or 3% of additional revenue growth, due to signing delays.
To make up for the sales shortfall, the tech-services giants are borrowing a page from the upstarts: They, too, are trying to take over business tasks such as customer service by beefing up their own practices or forming joint ventures. In September, 2000, Accenture formed ePeopleServe, a joint venture with BT Group PLC (BTY ) that will assume management of human-resource departments for clients.
When business is nailed, it's likely to be at a lower rate. Take General Motors Corp. (GM ), which is now renewing up to 45% of its business with EDS, say analysts. GM Chief Technology Officer Tony Scott says he expects to get better prices for some services. "We're going to them now and saying `Look guys, we need to have some cost containment."'
The upshot of all these changes is increased bargaining power for customers. Rather than fixed-price contracts, customers are increasingly demanding deals that allow them to pay for services as savings are delivered. Earlier this year, when Washington Mutual Inc. (WM ) renegotiated a deal with IBM, a key demand was that it be released from its exclusive contract. "We're trying to increase the level of accountability," says Jeremy V. Gross, Washington Mutual's chief information officer, who is talking with several outsourcers.
It's a brutal world for tech-service providers--one where contract renegotiations may continue to gnaw away at the industry's financial health.
By Spencer E. Ante in New York, with Andrew Park in Dallas