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 and other countries is going to decrease those firms' options with regards to outsourcing and offshoring?
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 heritage company's position in EMEA?
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.
