Outsourcing megadeals lose momentum

The IBM-JPMorgan contract--one of the largest outsourcing deals in recent memory--is not the only agreement worth a billion dollars or more that has unraveled or caused headaches. Recently, IBM rival Electronic Data Systems and Dow Chemical "mutually" terminated a contract valued at $1.4 billion.

So-called megadeals are seen as less profitable for services firms and may not provide the best value for clients. Mammoth contracts can also be challenging to manage, said Stan Lepeak, an analyst at research firm Meta Group.

"I think we're going away from the megadeals," Lepeak said.

IBM's deal with JPMorgan originally called for the financial services company to outsource a significant portion of its data processing infrastructure, including data centers, help desks, distributed computing, data networks and voice networks.

JPMorgan said the seven-year deal, forged with IBM in 2002, was cut short because JPMorgan's recent merger with Bank One improved the company's ability to manage its own technology and infrastructure.

But outsourcing--farming out information technology or business tasks--is thriving as a way for companies to cut costs and focus on their "core" business, according to industry analysts. A report last month from research firm Gartner said the worldwide outsourcing market is expected to grow from $293.4 billion in 2003 to $429.2 billion in 2008, an annual growth of 7.9 percent.

Earlier this year, Gartner predicted a shift away from full-service, 10-year, multibillion-dollar outsourcing deals for technology service providers. The trend will be toward smaller outsourcing agreements with specific business goals, according to Gartner.

That's not to say that the megadeal is dead. One day after EDS and Dow ended their billion-dollar contract, IBM announced that it had landed a seven-year IT services deal with Dow.

Still, analysts expect smaller deals to become more common. A general push for lower pricing is partly behind the shift, said Robert McNeill, an analyst at Forrester Research. Only a handful of services companies can handle an outsourcing contract covering a large variety of functions, he said. Breaking outsourcing tasks into smaller deals--say, just desktop computer management--means that more companies are capable of doing the work and providing a bid. "It makes it more competitive," McNeill said.

A less grand contract also enables a client to more easily understand what it's paying for, Gartner analyst Bruce Caldwell said. Buyers of outsourcing services have grown "smarter about how to craft these deals," he said.

In addition, huge deals aren't necessarily wonderful for services firms. EDS said that in 2003, it suffered operating losses of $255 million from a major commercial contract--pegged by analysts as the deal with Dow. EDS would not verify that, but it said it reached an agreement to terminate the unnamed commercial contract as of Aug. 1, the same day it said its contract with Dow effectively ended.

EDS also has had a hard time with a multibillion-dollar contract to upgrade the U.S. Navy's computer and communication systems. The contract has been delayed for reasons that include "inefficient program management," according to EDS. In the second quarter, EDS reported an operating loss of $171 million associated with the contract.

Lepeak said EDS hopes to recoup its investment in the Navy contract over time and that quitting the deal would lead to large penalties and a black eye for the company. But he suggested that the contract has been more trouble than it's worth.

"I think they'd love to walk away from that, but they can't," he said.

EDS spokesman Kevin Lightfoot said the company's "sweet spot" for outsourcing contracts is deals valued at less than $250 million. But EDS isn't done with megadeals. It recently inked a $1.1 billion, eight-and-a-half-year contract with Bank of America.

EDS' new communications infrastructure contract builds on an earlier outsourcing agreement. EDS assumed responsibility for the Bank of America network in early 2003 as part of a 10-year, $4.5 billion contract.

By calling off its outsourcing agreement with IBM, JPMorgan is taking an alternative post-merger route than the one chosen by Bank of America, which agreed last year to merge with FleetBoston Financial.

But though JPMorgan is ending its big outsourcing contract, Lepeak said he wouldn't be surprised if the firm ends up outsourcing some of those IT tasks after all--as smaller deals, of course.