WILL OUTSOURCING STILL FLY?
The financial troubles of US-based global outsourcer EDS have raised questions about the long-term viability of outsourcing . But the answers are mostly upbeat.
By Alix Nyberg and Karen Winton

Before Christmas 2002, the global outsourcing industry seemed poised for a tailspin - if outsourcing giant EDS was any indication. Drained by soured bets on its own stock, a drop-off in new business, and a crop of troubled existing customers (including Worldcom and the bankrupt US Airways), US-based EDS shocked investors with its announcement that it would miss earnings targets. Those troubles, combined with a credit rating downgrade, meant it might become harder for EDS to get the cash needed to maintain operations for customers. And that prospect led some to speculate that outsourcing deals in general would no longer be as sweet as they once were.

"The market has seen what can happen when deals are unfavorable to the outsourcers, and companies will likely think long and hard about being aggressive in their negotiations," one analyst who follows EDS and other major outsourcers told CFO at the time. That EDS was renegotiating some of its worst performing contracts, like the US$6.9 billion US Navy agreement, only heightened the expectation that outsourcing could get more expensive.

But three months later, consultants say EDS's financial problems have had little effect on the deals struck by outsourcing clients for IT services such as data networks, servers, and storage. Instead, they say, customers are continuing to wield their buying power for all it is worth. "I've seen some of my clients ask for things that would have been ridiculous two years ago," says Bob Pryor, head of Cap Gemini Ernst & Young's outsourcing consulting practice in the US.

And just because a contract isn't set to expire is no reason not to renegotiate it. "About one-third of our business is renegotiating arrangements signed between 1998 and 2001, when rates were higher, demand was stronger, and service providers had more control," says George Casey, head of the outsourcing consulting division of US-based Shaw Pittman, a law firm that specializes in outsourcing contracts. "Now that [companies are] finding they signed up for more volume than they needed at higher rates, we're trying to bring [their contracts] back in line."

This buyer's market for outsourcing may be one of the reasons that analysts are predicting big growth in the practice this year, both in its local and offshore variety. "We're seeing a major change now," says Dion Wiggins, the Hong Kong-based research director for Gartner Group, the technology research company. He adds: "In the past couple of years you were an early adopter if you took on outsourcing. Now you're the oddball if you're not, and it's going to be a critical part of your business." Cost, says Wiggins, is the prime mover. "It's another year of cost is king," he says, "and, by outsourcing, companies will be able to reduce costs and focus on core competencies." Wiggins estimates that by year-end 2003 more than 80 percent of US enterprises will have considered offshore sourcing, while more than 40 percent will have completed a pilot or be outsourcing IT services through a local or offshore delivery model.

One element adding weight to the negotiating position of the buyers is that suppliers' costs for major components of IT infrastructure management have actually gone down. The buyers know that there's still some room to gain concessions, and suppliers of outsourcing services are able to compete on price. In some cases, these price pressures have actually spurred outsourcers to work together to create economies of scale. In a promising development, outsourcers like EDS, IBM, and Hewlett-Packard have found ways to share equipment among clients more efficiently, allowing them to demand fewer volume commitments from their customers.

"The notion that you pay for everything, whether you use it or not, will fade," predicts John Lutz, managing director for the financial services sector at IBM in the US. Instead, "there's been a real emphasis on not just cutting costs, but making them more visible, and more able to scale up and down as business volumes fluctuate."

This pay-as-you-go, utility-like approach was a key feature in the US$5 billion, seven-year deal IBM recently inked with JPMorgan Chase for IT and business process services, as well as in deals with American Express and Deutsche Bank, Lutz says. He expects the approach to become an industry standard in future - despite the risk it poses to IBM's revenues. "This is a balanced risk that we're delighted to take," he says, "because the last thing you want in any contract is something that causes you to drift away from the customer."

A world in which IT infrastructure services are simply priced by the units a company consumes, like heat or electricity, is several years away, caution analysts, particularly in Asia Pacific, where outsourcing is really still an opportunity only in established markets such as Australia, Japan and Singapore. For one thing, many of the technical procedures that would allow an outsourcer to share equipment such as servers have yet to be perfected, according to Bruce Caldwell, principal analyst for Gartner's US-based Dataquest unit. And even when technology allows the outsourcers to offer more flexibility, buyers will have to be wary of hidden cost increases.

"It's going to be very challenging for vendors to [price] this in a way they can survive," says Caldwell. "They will probably have to add some consulting and other services to make a reasonable profit on these deals." A trend toward measuring results in terms of business processes, rather than technical terms like network availability or response time, may also help mask some price increases over previous contracts.

Benchmarked Deals

While waiting for these changes to take hold, many companies are looking to secure frequent, if not real-time, price and volume adjustments by beefing up the benchmarking provisions in their outsourcing contracts, experts say. "Benchmarking is ideal for both supplier and customer," says Steve Fitz, president, Asia Pacific/Japan for network storage provider EMC. "But I think those types of transactions are few and far between in Asia. It's a question of economics. CFOs hold the pocketbook. They question a contract and ask, 'why aren't there two or three quotes versus one? Is one partner so strategic that the business needs to be sole-sourced?' And if it doesn't have a good business case and the prospect of a better TCO, forget it." Fitz says that for the vendors, the challenge is to present a business case that makes sense, that's going to show how to save or make money. "If we can't do that, then a CFO won't want to do business with us."

At US-based benchmarking firm Compass America, the volume of requests to benchmark the terms of IT outsourcing agreements has grown about 20 percent per year in each of the last five years, with the same growth expected for this year, says vice president of consulting Rod Hall. And, he says, more companies are using the data to push for change.

"Historically, every contract would be worded differently, and it typically wouldn't specify what the comparable data would be, what level of analysis would be done, or whether it would be benchmarked on price or cost," says Hall. Without such details, vendors' standard arguments that the contract in question was unique often stymied the process, or at least rendered its results ineffective.

At Hong Kong-based telecommunications carrier Hutchison Global Communication, for example, the general manager of the company's corporate market, Andrew Lee, says that instead of offering traditional telecommunication services - connectivity and basic voice services to customers - the company now outsources the provision of additional equipment. "There is customer demand for us to combine our network services with customer premises equipment, digital voice services, high speed optical networks, bandwidth and interface, so we are now tailor-making total solutions in terms of network and equipment," says Lee.

What this has meant in terms of the service level agreements that Lee's team now negotiates is that they are both standard - for example, in terms of setting financial compensation in the event of network failure - and tailor-made for sophisticated projects where a network spans more than one country or involves, for example, a high-speed optical network such as DWDM (dense wavelength division multiplexer).

"More and more customers are outsourcing their network requirements to companies like us," notes Lee. And while Hutchison's core business remains telecommunications, because of the requirements of customers for systems integration, close cooperation with business partners like EMC and Nortel enable the Hong Kong-headquartered telco to offer customers a total solution. "Demand has seen our growth in this area reach double digits in each of the past couple of years," adds Lee.

With the current pressure on companies to cut costs, in the US "benchmarking agreements have evolved to be more useful," says Jenny McClennan, counsel for Shaw Pittman. Many specify the comparison pool up front, she says, and also spell out the process for renegotiations should the benchmarking turn up a material discrepancy in prices. In many cases, contracts say a customer must be given "most-favored customer" status, receiving the best prices that the outsourcer gives to any client. Adds Hall: "We've seen a number of cases where just the fact the client has indicated it's thinking of benchmarking will start the process of renegotiations." In one instance, he says, a large outsourcer even promised a major client rock-bottom rates if it would forgo its right to benchmark for the duration of the contract.

Companies, though, say getting a read on how their terms compare with the market is useful for a variety of reasons beyond pricing. US-based DuPont, which is in its sixth year of a US$4 billion joint outsourcing agreement with Computer Sciences Corporation (CSC) and Accenture, says it plans to incorporate benchmarking data into all its renegotiations, given the success it recently had in using such data to tweak a networking services contract with CSC.

After working with internal staff and external consultants to define the services it was getting and "minimize any uniqueness we might have," says Diane Strickler, director of technology integration, DuPont told CSC that it would compare its bid to the market prices for the services.

The company generally benchmarks at least one segment of its outsourced functions per year, says Strickler. "But what was different this time was that we brought [the data] in upfront rather than after the fact, which shortened the price negotiations by weeks, a considerable amount." The comparison data has been valuable for internal use as well. "You can assure the user community that you're getting a competitive price," she says. "And if there's noise of 'we could do it cheaper,' you can quiet it before it becomes an uproar."

Double-Edged Sword?

TBenchmarking leads to renegotiated rates in about half the cases, say experts. One of the biggest limitations of the process is the difficulty of finding other companies with a similar package of services, and finding out their prices. That's just one of the reasons an outsourcer might use to argue for staying with the original terms. "It's very common for the first tier and even some second tier providers to have teams dedicated to responding to benchmarking," coming up with reasons why the price differentials don't merit a change, says Hall. "That puts the customer at somewhat of a disadvantage."

In some newer contracts, outsourcers actually have the option to raise prices if it turns out they're in the low end of the market. "It could be a double-edged sword - there's nothing that guarantees negotiations will always be in favor of the user," says Strickler. While that's not often done in practice, according to consultants, it could become a likelier prospect if vendors begin to suffer.

As companies press their advantages with vendors desperate for volume, some say the worries about the long-term health of the industry are not unfounded. The numbers are staggering. IBM, for example, is said to have US$100 billion of backlog for services revenue. "The way most of these things are set up is that you have to take a reserve against some of the future revenue that's either on the books or that would be accrued," says EMC's Fitz. "So in the event that the company fails, you [as a company] and your shareholders won't be exposed."

Still, Moody's has kept EDS on its credit watch list, in part because it anticipates "there will be a tension to renegotiate, which could have adverse implications for forecasted financial results." Seen in that light, outsourcers may have to make tough business decisions - like walking away - to remain viable.

"Their challenge is to make sure they enter into good contracts and don't make dumb concessions," says Cap Gemini Ernst & Young's Pryor. "Certainly, it takes a lot of emotional fortitude to walk. But if you don't, it really calls into question your risk as a service provider."

Alix Nyberg is a staff writer at CFO, CFO Asia's sister publication in the US. Karen Winton is executive editor of eCFO and a senior writer with CFO Asia in Hong Kong.