Services megadeals not quite so mega

But what's hiding behind the big numbers are the costs involved in following through on those megadeals--costs that can be substantial.

IBM, for example, recently boasted of a $1.1 billion, 10-year information technology services contract with Swiss power and automation technologies company ABB.

Big Blue said that, along with roughly $600 million generated by two other contracts signed in late 2001, its revenue from ABB will approach $1.7 billion over 10 years. But IBM isn't likely to rake in profits anywhere near $170 million a year, at least initially. Because it is hiring nearly 1,300 ABB employees as part of the deals, IBM is looking at yearly personnel expenses that probably top $90 million.

Analysts say the IBM example is typical of large IT services contracts. Services providers frequently have to make substantial investments in IT equipment and personnel. What's more, clients are renegotiating contracts along the way, which can trim profits further, said analysts.

The real value of the deals may be long-term relationships and repeat business years later.

"What's being acquired here is really a client relationship," said David Garrity, an analyst with equity research company American Technology Research.

That could explain the spate of big deals announced in recent months, and an overall growth in the number of billion dollar-plus contracts being signed by services companies.

In May, HP said it finalized a deal worth $3 billion over 10 years to manage Procter & Gamble's overall IT infrastructure. In August, Computer Sciences boasted it won a 10-year, $342 million IT outsourcing contract with Malaysian banking group Malayan Banking.

IBM, meanwhile, announced a seven-year IT outsourcing contract with beverage company Diageo. Analysts familiar with the deal estimated its value at $400 million to $500 million.

Megadeals are usually IT outsourcing arrangements lasting for at least several years, where services companies take over tasks such as developing software applications, running data centers or managing desktop computers. Last year was a big year for the biggest deals. There were at least 14 IT infrastructure outsourcing deals worth $1 billion or more in 2002, compared with nine such deals in 2001, according to researcher Gartner Dataquest.

TPI, a consulting company that helps arrange outsourcing contracts, said that in 2002, the total value of all IT-focused outsourcing deals worth more than $200 million added up to $41.4 billion, versus $38.8 billion in 2001. Including "business process" outsourcing deals, which involve farming out business tasks such as call center operations or accounting, the total value of outsourcing deals worth more than $200 million rose from roughly $46 billion in 2001 to about $50 billion last year, according to TPI.

The number of big deals will most likely decrease in 2003, TPI has predicted. But Garrity is bullish about big outsourcing deals over the next three to five years. Businesses can use megadeals to cut costs, and may see outsourcing as an attractive option as they look to upgrade their computer gear, he said.

The emergence of so-called utility computing initiatives, which aim to convert computing to a pay-as-you-go service such as electricity, also could spark big deals, Garrity said. The overseas market in particular is fertile, he said. "You may see more megadeals coming out of Europe, and you may see more megadeals coming out of Asia," he said.

Read the fine print
Still, the deals may not be as sweet as they seem. IBM's contract with ABB is a case in point. Under the new agreement, announced in July, IBM said it will take responsibility for the operation and support of information systems infrastructure in 14 countries in Europe and North America--representing some 90 percent of ABB's IS infrastructure.

IBM is taking on about 780 ABB workers, on top of 510 ABB employees absorbed from the two earlier contracts. Forty-four of the already-transferred ABB employees were from India. Garrity estimates that the annual cost of European and North American workers is roughly $75,000 to $100,000, while the Indian workers probably set back IBM $15,000 to $25,000 a year. Thus, a conservative estimate for the annual personnel costs Big Blue is picking up in the deals is about $94 million.

Neither ABB nor IBM would provide information on the annual expense of those employees. But ABB spokesman Wolfram Eberhardt indicated that shifting workers to IBM is a big reason the company expects to save $50 million annually over the next decade. "Most of these costs are labor costs," Eberhardt said.

The deal doesn't guarantee the affected workers a job with IBM for the next 10 years, Eberhardt said. And it's possible IBM will use some of those workers to generate additional revenue by putting them on other client accounts, suggested Michael Melenovsky, analyst with market research company IDC. What's more, Melenovsky said, some of ABB's IT work now done in Europe could be transferred to India, which could shave costs.

However, megadeals like the ABB contract can trigger costs beyond labor. Garrity said that in most outsourcing deals, service providers face capital expense costs in equipment and connectivity charges of 5 percent to 10 percent of the face value of the contract. IBM may be avoiding a big hit in this area, because ABB was already leasing equipment from IBM.

IBM declined to disclose the amount of profit it expects from the ABB deal.

Overall, megadeals generally are less profitable than smaller ones because of stiff competition in bidding, Garrity said. He pointed to Affiliated Computer Services, an IT and business-process outsourcing company whose contracts usually do not break the hundred-million-dollar barrier. ACS' operating profit margin tends to be higher than that at EDS, Garrity said.

Meanwhile, megadeal profit margins are under pressure. IDC's Melenovsky said it's more common now for clients to renegotiate long-term deals with their service providers, for reasons including bankruptcy filings and company reorganizations. He said client restructurings are likely the cause of EDS's admitted "under-performing contracts." If a client sells a division, "it means EDS has to go in and figure out how that division can be torn out of the deal," Melenovsky said. That can translate into less revenue for EDS.

In this climate, service providers are being more careful not to suffer in the initial phase of a big contract, Melenovsky suggested. "Back in the mid-'90s, it was very common for a company like IBM or EDS to lose money in the first 18 months," Melenovsky said.

Contract clauses calling for "benchmarking" also are squeezing margins, Garrity said. Benchmarking allows the client to check its fee rate in an outsourcing deal against current market rates, and push the service provider to lower its rate if market rates are substantially lower, Garrity said. Unfortunately for providers, "it doesn't go in the other direction," Garrity said.

Still, clients have an interest in not squeezing too hard. After all, they don't want their provider to go out of business and suddenly leave vital computer operations in limbo. EDS's drastic earnings shortfall last year raised fears it could be in trouble, Melenovsky said. "The issue starts to become, We want the service provider that we're outsourcing to, to be healthy financially," he said.

Plano, Texas-based EDS reported net income of $138 million for the June quarter of this year, and met analysts' average expectation for earnings per share. Since posting earnings well below expectations for the third quarter of 2002, EDS has replaced its CEO and announced a focus on outsourcing services.

Outsourcing megadeals may not be as glorious as their lofty revenue values suggest, but they have advantages. One is recurring revenue that's generally stable over the course of several years. Another is the chance to gain additional work beyond that specified in the original contract. "It's not out of the question to see the size of the engagement crop up 5 percent to 10 percent," Garrity said.

There, Garrity said, the benefit of the megadeal is that the service provider knows what's going on in the client's business before potential competitors. "You've got your foot in the door," he said.