Today's blog comes from Peter Allen,
Partner and Managing Director, TPI
With this week’s release
of the Global TPI Index for third quarter 2008, I’ve been presented with a
number of hard-hitting questions by the media, service providers and the global
equity research community. Instead of addressing these one-on-one, I wanted to
share my answers with all readers. If you have added questions, feel free to
post them here.
It’s clear from the
questions that the current economic meltdown is driving concern for the future
of the outsourcing industry. The objective of my answers is to bridge the gaps
between market expectations that precipitate from the current economic crisis,
as well as future trends in the outsourcing industry. Several forces are at
play, ranging from budget cutting, debt limitations, pressure on profit
margins, dramatic restructuring of corporations comprising the financial
services industry, and government involvement. There’s a lot of speculation and
even more questions, which is understandable given the current volatility and
uncertainty in the global economy.
Let me know if you
agree or see things differently. I’m interested in hearing your point of view.
Q: Are
you seeing budgets getting cut in 2008 compared to previous years?
A:
Budgets for “back office” functions in virtually all companies in all
industries are being scrutinized and, in many cases, reduced. We hear of some
rather extreme challenges being laid on CIOs, CHROs, and business executives. There’s a focus on entering the new calendar
year with an adjusted run rate for operational expenses – run rates that better
align with the demand profile for goods and services for those companies. This
is prudent management in the face of uncertain economic circumstances. In
recessionary markets, when consumption decreases, it is natural to reduce
capacity for servicing that demand. The percentage of impact varies by industry
and function. If a company isn’t hiring new employees to service growth, then
the HR department isn’t going to get investment in new capacity. It’s as simple
as that. What this means to the outsourcing industry is two things. Firstly, existing contracts will be called
upon to dial-back aspects of service to reduce the total costs to the Client. As I said on the TPI Index call, a
well-designed outsourcing contract has many levers available to achieve
variability in costs. The second effect
is a delay in starting new projects, even those that have positive implied
returns.
Q: As
times get tougher going into 2009, shouldn't we see the growth rate towards
outsourcing accelerate?
A:
Yes, and growth will come in two forms. Existing outsourcing arrangements may
see scope expansion as clients conclude that the favorable economics of those
relationships allow for near-term benefits by doing more work via cost-effective
service providers. This is not the inverse of my prior point about Clients making
selective use of available cost-control levers.
Rather, this growth will come through added scope to those providers who
have weathered the recessionary storm with their Clients. Secondly, we’ll likely see an upturn through
divested operations and associated services agreements. I think this will be a
significant characteristic of the early-2009 marketplace. Those are the
near-term upsides via outsourcing. Broader, transformational-oriented
outsourcing may take a while to return to flight.
Q:
Although service providers with low debt and good cash reserves might potentially
be in a position to buy financial services captives, what would their incentive
be, given that financial services companies are going through a period of
restructuring/uncertainty and may not necessarily be in a position to commit
business volumes?
A:
Leverage. The providers must believe that there is a market — beyond a single,
large client — for an acquired asset. Taking over an existing capability, with
attendant scale, creates a proposition for the broader market that should drive
additional outsourcing. And, I think
this proposition transcends the financial services industry. We may find that the crash of 2008 gives rise
to creation of vertical industry BPO foundations. This has been a topic discussed for several
years, but the impetus may have arrived with the mandate to restructure
corporate services in order to avoid capital expense and operate with greater
variability and efficiency. This could
be the silver lining.
Q: Do
you think we will see some hasty deals thrown together to cut costs rapidly in
the near term?
A:
I sure hope not. This is a mature industry that has learned hard lessons about
hasty deal construction. Outsourcing is a long-term benefit that must be made
with forethought and strategic considerations. It’s a lifestyle change that is hard to
reverse. That said, the strategic
framework for making such decisions is a topic of frequent review in many
larger companies. For many, they may be primed to act on those plans.
Q: Do
you believe that the government ownership of significant stakes in financial
services institutions in the US, UK
A:
No. In virtually every case of a government investment in a financial services
institution, the government has expressed a strategy that is NOT oriented
around nationalizing those operations. Rather, these are strategic investments
that are expected to pay dividends through sound management. The tools of
management include the continued use of outsourcing and offshoring for
functions that are appropriate for those delivery models.
Q: Is
counterparty risk becoming a determining factor in vendor selection and
rationalization?
A:
I would not say that it is a determining factor. It is one of the many
considerations that are important to the parties in creating a long-standing relationship
that will serve the interests of both. Certainly, the concerns around
counterparty factors are more acute today, but they are not determinants.
Q: What
will the HCL acquisition of Axion do to the India
A:
HCL’s move to acquire Axon’s systems integration capabilities provides greater
potential for ERP-oriented solutions in EMEA. HCL is, like many other
India-heritage providers, a very capable firm that recognizes the benefits of
having a higher-order consulting and systems integration capability to connect
technology with business needs. To me,
this is an excellent example of the India-heritage community’s recognition that
their fortunes rest with business impacts that come through uniting technology
and operations. Having a
technology-oriented proposition is destined for the commodity category.
Q: The
Indian IT thesis has been a slowdown as budgets get cut, followed by an
acceleration towards more work offshore. Do you think that will hold true?
What's your best guess on timing for a recovery in the offshore systems
application and development markets?
A:
The near-term impact is non-trivial for the India-heritage providers which
enjoy a relatively higher concentration of discretionary, staff-oriented, contractual
relationships. Especially within the financial services sector, and related
industries that are dependent on consumer credit for spending, for the next
several months there is likely to be a pull back on investments. The return to
growth for applications-oriented projects will likely come through a new
paradigm for making such investment decisions, one that looks to maximize
leverage in development, maintenance and operations. I would estimate that
we’ll start to experience this in 2Q2009 timeframe.
Q: What
are your expectations for 4Q2008?
A:
A recent announcement of a mega deal provides early
momentum for the fourth quarter, and we are aware of several larger transactions that are
poised for award in the fourth quarter of 2008. This gives us a sense of a
pending award uptick and deal signs to pick up strongly, and this substantial activity that should allow 2008 to exceed 2007’s total
performance of $85 billion.
I feel that IT spend will undergo a qualitative change on the following lines:
-A lot more SI type work will come through in 2009 when consolidation starts getting operationalized. There will be demand for consulting around portfolio optimization, largely driven by consolidation fuelled redundancy.
-Contractor consolidation to drive efficiencies would be a low hanging fruit that organizations would seek to pick. This is especially true of those organizations where contractor diversity has been a decision making factor.
-Innovative financial models would gain importance as the credit crunch would mean less working capital. Large forex rate fluctuations and inflation would also drive this trend.
-Organizations would use the down period to re-skill the workforce and there could be consulting opportunities around the same.
Posted by: Prakash | October 20, 2008 at 02:30 PM
Prakesh,
Thanks for your reply here. I guess that I am feeling a bit more extreme about the current marketplace and the implications on outsourcing. Most of the behaviors/reactions you outline are customary to the cycles of economic ebbs and flows of the past.
Today's situation feels different to me. It feels far more structural.
I think we're going to see major realignment of organizations and operations. In essence, creation of new land masses.
I don't think we're talkign about picking up debris from a large storm.
Posted by: Peter Allen | October 20, 2008 at 05:33 PM