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EDS's financial troubles have raised questions about outsourcing deals, but the answers are mostly upbeat.
Alix Stuart, CFO Magazine
February 1, 2003
Last fall, the outsourcing industry seemed poised for a tailspin. Drained by soured bets on its own stock, a drop-off in new business, and a crop of troubled existing customers (including the bankrupt US Airways and WorldCom), Plano, Texas-based outsourcing giant EDS Corp. shocked Wall Street 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 $6.9 billion U.S. Navy agreement, only heightened the expectation that outsourcing could get more expensive.
But a quarter 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's worth. "I've seen some of my clients ask for things that would have been ridiculous two years ago," says Plano, Texas-based Bob Pryor, head of Cap Gemini Ernst & Young's outsourcing consulting practice in North America. 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 Washington, D.C.-based Shaw Pittman LLP, 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."
Costs for major components of IT infrastructure management have indeed gone down. And in one of the most promising advances, outsourcers like EDS, IBM, and Hewlett-Packard are developing ways to share equipment among clients more efficiently, allowing them to reap greater economies of scale and 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 Corp. Instead, "there's been a real emphasis lately 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 $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 going forward — 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. 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 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.
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. At benchmarking firm Compass America Inc., 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.
With the current pressure on companies to cut costs, though, "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. Wilmington, Delaware-based DuPont, which is in its sixth year of a $4 billion joint outsourcing agreement with Computer Sciences Corp. 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 director of technology integration Diane Strickler, 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 up front 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."
Benchmarking 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 Tier 1 and even some Tier 2 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. 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 CGE&Y'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.
Failure Is Not an Option
While the prospect of an outsourcing firm going into financial ruin is not a pleasant one, customers of WorldCom and others in Chapter 11 have found that it's not as bad as they might have thought. "Practically speaking, vendors are going to service customers until they no longer can," says David Hudanish, a partner at San Francisco-based Brobeck Phleger & Harrison LLP who specializes in outsourcing contracts. "They absolutely don't want to lose their customer base, or [failure] will become a self-fulfilling prophecy." Financially troubled outsourcers "definitely make [customers] uneasy," adds Dana Stiffler, an analyst with AMR Research, "but whether [customers] actually suffer a decline in the business's ability to operate is questionable."
That's a lesson that Farmington, Connecticut-based air-conditioner giant Carrier Corp., a United Technologies company, learned as Genuity floundered into bankruptcy. When Carrier engaged the hosting company in 1997 to run its business-to-business Web sites, which now process more than $10 million worth of transactions, it looked like a solid bet. Genuity was an offshoot of the more-established GTE Corp. and financially backed by GTE's acquirer, telecommunications giant Verizon. But after Verizon yanked some of its equity and Genuity's $1.15 billion borrowing privileges last July, things quickly went south for Genuity — sending its business into Chapter 11 and leaving its customers more than a little concerned.
"Our biggest fear was that they would get completely shut down and there would not be a buyer," says Rob Hack, who oversaw the deal with Genuity as Carrier's thendirector of global information technology and infrastructure. If that had happened, he estimates it would have taken six to nine months to build a new hosting site with another outsourcer, cutting off critical business transactions for an unacceptably long time.
Instead, even in the most uncertain days, before Level 3 Communications agreed to acquire Genuity, "we experienced no degradation of service," says Hack. In fact, he says the service has been "outstanding." At press time, Carrier was planning to move more servers under Genuity's management this year, and forge a new deal with Level 3. —A.N.