Stan Lepeak, Managing Director, EquaTerra Global Research

I recently participated in an equity analyst event focused on the IT services and software markets, hosted by Karl Keirstead of Kaufman Brothers. In addition to being one of the most competent sell-side analysts covering the business and IT services market, Keirstead is also one of the more cynical, or realistic, depending on how you look at it.

So it was perhaps in the atmosphere of business and IT services market realism versus hype that the discussion turned to what the root causes of the ongoing underperformance are, at least from the perspectives of buy- and sell-side equity analysts, among many of the top business and IT services providers and, by reflection, the market as a whole. Highlighting the reality versus hype point, Keirstead currently has “sell” ratings on two leading service providers typically viewed as top of class.

While there is no direct correlation between a stock picker’s rating and a service provider’s ability to deliver quality offerings, at least in the short term, a down rating is one of several indicators of possible longer-term financial headwinds that can signal potential service delivery challenges. Underperformance from a financial perspective, driven by “bad” outsourcing deals, has contributed to several major providers’ shift in focus, mergers and acquisitions, and other life events over the past several years.

Beyond specific stock and financial performance, there are other signs of a malaise in the outsourcing market, at least among the top tier providers and based on the traditional definitions of BPO and ITO:

• Outsourcing deal flow disruption has continued into its second year, as buyers remain hesitant to pull the trigger on new efforts and instead seek other alternatives, such as internal process improvement, to address organization business challenges.
• Despite an economic environment highly focused on cutting costs, outsourcing is not always the top business tool employed in cost cutting efforts, with “going without” or simple layoffs proving more preferable to many organizations.
• Outsourcing deals are getting smaller but no less complicated, and buyers are getting more aggressive in how they engage service providers.
• Automation and IT virtualization are enabling an increasing number of buyers to achieve typical outsourcing goals, (e.g., cost reduction and process improvement), without having to go through full-blown outsourcing.
• New services market entrants via the cloud and software-as-a-service (SaaS) are disrupting the competitive landscape for business and IT services.

The reality is that one person’s malaise (think Jimmy Carter) is another’s market changing opportunity (think Ronald Reagan). While the above five bullets do accurately characterize today’s outsourcing market, whether they are good or bad signs depends on your perspective, market position and whether you are a buyer or seller of services.

The business and IT services market has matured, especially over the past five years. Much of the low hanging fruit, (e.g., bloated IT organizations, legacy homegrown IT environments and excessive cost models), has already been picked through existing outsourcing efforts or via aggressive cost cutting efforts that have occurred over the past two years. Quick and big wins via outsourcing are fewer and father between. Buyers and providers are smarter, more experienced and less likely to enter into larger and more risky deals. And evolutionary innovations like cloud computing are changing the nature of what constitutes outsourcing.

Outsourcing buyers or services providers with legacy mindsets and operating models will find current market changes threatening and a long-term negative indicator. Similarly, if the outsourcing market is viewed through the legacy lens of traditional deals, models and providers, it is in decline. However, setting nomenclature aside for a moment, if focus and emphasis are placed on the means by which buyers can tap into party bundles of hardware, software and expertise, (outsourcing at its core), the market is stronger than ever, albeit more confusing and fragmented for the next few years thanks to cloud and SaaS.

<<Note: for those attending the upcoming Global Sourcing Forum in New York city in late October 2010, I will be on a panel with Karl Keirstead and the esteemed Phil Fersht of Horses for Sources. >>

Filed under: Market Trends and News, Outsourcing by EquaTerra