FY2002 Data Shows Shifting Margins for Systems Integrators

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1 Research Brief FY2002 Data Shows Shifting Margins for Systems Integrators Abstract: The latest data indicates that expertise in the areas of business processes and vertical markets is more important than technical expertise in driving systems integrators' margins. By Martin Lee Recommendations Vertical and process expertise skills attract the highest margins. Systems integrators must evolve their business model to incorporate their expertise in those areas. In the long run, technical skills are not real differentiators, unless you are on the "bleeding edge" and can stay there. Business knowledge particularly in terms of process or industry knowledge should be treated as an important differentiator. Staff augmentation companies will find their position and margins eroded as such factors as offshore outsourcing take control of the market. Staff augmentation vendors must explore ways of extending their core competencies into other services. Ideally, they should pursue a strategy that will differentiate them in the marketplace. Publication Date: 2 December 2003

2 2 Systems Integrators' Margins, FY2002 Introduction This research is an update of "Choosing Right Niche Yields Higher CSI Margins," ITSV-WW-DP The previous Perspective covered fiscal 2001 margins for systems integation (SI) companies characterized by similar operating models, and this version covers fiscal 2002 margins, using the same methodology. Gartner Dataquest gathered profit and loss statements for 28 publicly traded U.S. consulting and systems integration (CSI) companies for fiscal 2001 and 2002 from public documents available from the Securities and Exchange Commission's Electronic Data Gathering, Analysis and Retrieval site. To calculate the margins, we added all of the profit and loss statements for a subcategory and then calculated the overall margin for that subcategory. We used the companies' top-line financial statement because most companies do not break out the financial data for their SI divisions. Therefore, some of these figures will include a mix of other services. However, to improve comparability, we have included only companies that claim SI as their top service line, in terms of revenue. The data in this Perspective is not directly comparable with last year's. Many of the companies had to restate their 2001 financial statements to comply with a Financial Accounting Standards Board's ruling that reimbursed expenses must be included in any IT services company's revenue and cost of service. Many companies previously did not include this as it reduced overall margins. The 2001 data has been updated for this report and is directly comparable with the 2002 data. Business Trend After three years of turmoil and slackened demand, the margins for most SI companies have taken a big hit. Are any categories showing signs of renewed margin performance? The categories to be examined are as follows: Big Five public consultancies A CSI company that has Big Five roots and that is now publicly traded, such as Accenture and BearingPoint. Enterprise application integrators Vendors that primarily implement enterprise applications (often called packaged application implementers), such as AnswerThink, BrightStar Information Technology, Cotelligent, Intelligroup, Sapient, Tanning Technologies and Technology Solutions E-business integrators Vendors that primarily integrate e-business systems, such as Braun Consulting, DiamondCluster International, E-loyalty, Inforte and Zamba 2003 Gartner, Inc. and/or its Affiliates. All Rights Reserved. 2 December 2003

3 Gartner Dataquest Perspective Integrators with software systems Vendors that have base software systems that they sell and for which they provide the development and integration services related to the software, such as American Management Systems, Tier Technologies, and Systems and Computer Technology Vertical specialist integrators Vendors that focus on one vertical sector, such as CACI, DAOU Systems, First Consulting Group and Superior Consultant Holdings Staff augmentation companies Vendors that provide IT staff to clients, such as Analysts International, Ciber, Computer Horizons, Computer Task Group and igate Capital Application development and management outsourcing companies Vendors that evolved their staff augmentation business into application development and management outsourcing services, such as Keane and Syntel Big Five Public Consultancies' Margins The gross margin for the two public former Big Five consultancies fell from 2001 to 2002, from 37.4 percent to 34.1 percent (see Table 1). Despite this drop, these companies improved their operating margins. Unfortunately, unprofitable investments on the part of Accenture and a cumulative effect of a change in accounting principle on the part of BearingPoint dropped the net margin once again, just as in But once again, it was one of the few segments to record a positive net margin overall. Table 1 Big Five Public Consultancies' Margins, (Percent) Gross Margin Operating Margin Net Margin Enterprise Application Integrators' Margins The margins for enterprise application integrators fell greatly in 2002 (see Table 2). This follows an overall fall in the preceding year. Gross margins were down from 31.2 percent in 2001 to 26.5 percent in 2002, a slide of almost 5 percentage points. A decline in software license sales led to overcapacity in related services, which caused pricing pressures. At the same time, the software vendors tried to capture market share in implementation and maintenance through their services arms Gartner, Inc. and/or its Affiliates. All Rights Reserved. 2 December 2003

4 4 Systems Integrators' Margins, FY2002 Revenue was down 38 percent year over year, making it hard for companies to adjust their staff composition to recognize the greatly reduced demand. General and administrative staff, as well as sales staff, were configured for much higher revenue generation, and when the sales did not come, their operating and net margins suffered. Table 2 Enterprise Application Integrators' Margins, (Percent) Gross Margin Operating Margin Net Margin E-Business Integrators' Margins The gross margin for e-business integrators fell by half in 2001, and it fell again in 2002 (see Table 3). Operating and net margins declined even more. Margins for this segment have been much worse than for other segments as end users either cut back on their e-business spending or went with more-established companies. In addition, as evidenced by the decline in the number of companies in the group (from nine to five), many companies were not doing well and were bought out by other companies. Restructuring and layoffs took a heavy toll on the remaining vendors' bottom lines, as well as on declining sales. Revenue was down 34 percent in But ordinary operating expenses were also much too high to support revenue levels, which was a reflection of the severe overstaffing and underutilization that are the result of drastically declining revenue. Table 3 E-Business Integrators' Margins, (Percent) Gross Margin Operating Margin Net Margin Integrators With Software Systems' Margins As can be seen in Table 4, unlike the other segments discussed so far, integrators with software systems managed to keep their gross margins high. The margin was 38.8 percent in 2001, improving to 40.4 percent in 2002 the second consecutive year of improvements. This was the only segment to increase gross margins in Gartner, Inc. and/or its Affiliates. All Rights Reserved. 2 December 2003

5 Of course, part of the reason the margins are high is that software is incorporated in financial statements and is not separated. However, these companies' fundamental structure is to provide CSI services, and the software replaces systems development they would have done as a custom project. Operating and net margins did not fare as well, especially because some of the companies were disposing of some discontinued divisions. But these integrators remain one of the profitable segments, if barely so, at the net margin level. Table 4 Integrators with Software Systems' Margins, (Percent) Gross Margin Operating Margin Net Margin Vertical Specialist Integrators' Margins This segment saw its gross margins slip slightly from 36.1 percent to 35.7 percent, but it moved up from the third highest gross margin to the second highest (see Table 5). This reflects the additional margins available to companies that can demonstrate industry knowledge. In 2002, they raised operating margins higher, and this showed up in net margins that swung from negative to positive territory. Table 5 Vertical Specialist Integrators' Margins, (Percent) Gross Margin Operating Margin Net Margin Staff Augmentation Margins The staff augmentation companies had the second lowest gross margins of all the groups, as would have been expected, given their commoditized services and the current glut of technical people relative to demand. Only the perilous state of e-business services kept this group from the bottom. While gross margins fell by about 1 percentage point in 2002, reflecting the heightened competition, vendors brought some of that to the operating margin line, but their net margins suffered because of cumulative changes in accounting principles (see Table 6) Gartner, Inc. and/or its Affiliates. All Rights Reserved. 2 December 2003

6 6 Systems Integrators' Margins, FY2002 Another factor that greatly affected this industry was offshore service providers. With costs that are half or even less of most domestic staff augmentation companies, even with price levels 20 percent to 30 percent below domestic suppliers, these offshore service providers still had high margins, making it harder for the companies in this segment to survive. Companies in this segment need to look at their core competencies to see what other niches they can move into, as some have already done in shifting toward application development and management outsourcing. Table 6 Staff Augmentation Companies' Margins, (Percent) Gross Margin Operating Margin Net Margin Application Development and Management Outsourcing Margins Why are IT management services companies included in this analysis? Because the companies were formerly staff augmentation companies and have evolved their offering to be primarily application development and management outsourcing. Margins for these companies are higher than that for the staff augmentation companies, reflecting their focus on higher-margin services. They had problems with gross margins like most other segments, watching their gross margin fall from 31.2 percent in 2001 to 30 percent in 2002 (see Table 7). However, unlike most other segments, these companies were able to bring more margin down to the operating and net levels. They were easily the most-profitable segment in terms of 2002 net margin. Table 7 Application Development and Management Outsourcing Companies' Margins, (Percent) Gross Margin Operating Margin Net Margin Comparison of Margins, 2001 All the margins referenced for 2001 are shown in Table 8 for comparison across the different operating models. Gross margins for these groups, for the most part, range from about 27 percent to 40 percent. Obviously, the enterprise application segment and the e-business integrators segment had structural problems with their business models, which resulted in large losses on the operating level. Most of the other segments were profitable at the operating margin level and at the net margin level Gartner, Inc. and/or its Affiliates. All Rights Reserved. 2 December 2003

7 7 Table 8 Comparison of Margins, 2002 (Percent) Gross Margin Operating Margin Net Margin Integrator With Software Systems Vertical Specialist Integrator Big Five Application Development and Management Enterprise Application Integrator Staff Augmentation E-Business Integrators There was a substantial spread between those with above-average gross margins and those with below-average gross margins. The groups with above-average gross margins were integrators with software systems, vertical specialist integrators and Big Five integrators. The two with the lowest gross margins were staff augmentation companies and e-business integrators. Integrators with software systems had the highest gross margins by a wide margin with more than 40 percent. Vertical specialist integrators had the second highest at 35.7 percent, followed by the Big Five public consultancies at 34.1 percent. There are different leaders in operating and net margins, but generally the same group of operating models led the way. The Big Five public consultancies had the highest operating margin at 9.8 percent, followed by application development and management outsourcing companies at 5 percent and integrators with software systems at 3.6 percent. Application development and management outsourcing companies had the highest net margin, at nearly 4 percent, followed by the Big Five public consultancies, at 1.4 percent and vertical specialists, at 1 percent. Gartner Dataquest Recommendations What do all these numbers show us? Once again, the groups with the highest margins are, by far, the integrators with software systems, the vertical specialist integrators and the Big Five heritage systems integrators. That is because vertical and process expertise knowledge drives higher margins, and these three segments have that knowledge. This type of expertise can help systems integrators survive bad IT spending times like this because such expertise is even more valuable when times are bad. The same cannot always be said for IT skills. Hence the e-business integrators and enterprise application integrators have been particularly hit by the downturn as their core value is tied more to their technical knowledge than to their industry or process knowledge Gartner, Inc. and/or its Affiliates. All Rights Reserved. 2 December 2003

8 8 Systems Integrators' Margins, FY2002 Offshore outsourcing will be a long-term crimp in the U.S. staff augmentation market. Offshore outsourcing can, potentially, take over much of this market because its business model allows these companies to price engagements much lower while still having outstanding margins. These companies need to stem the tide by determining what assets they have acquired or developed over time, whether that means client relationships or industry/process knowledge picked up via client engagements. One particularly successful way that staff augmentation companies have transformed their business has been to move into application development and management. That utilizes a rapidly commoditizing skill application development to gain experience and expertise in the client's application areas, which, if systematically captured, will help develop industry and process knowledge bases within the company that can be leveraged in the future. The next step in the evolution of this business model would be to develop an industry-specific software system that could be leveraged and sold to a number of clients as a base system to build on. Key Issue What are the industry benchmarks and major trends in operational performance for IT service organizations? This document has been published to the following Marketplace codes: ITSV-WW-DP-0560 For More Information... In North America and Latin America: In Europe, the Middle East and Africa: In Asia/Pacific: In Japan: Worldwide via gartner.com: Entire contents 2003 Gartner, Inc. and/or its Affiliates. All rights reserved. Reproduction of this publication in any form without prior written permission is forbidden. The information contained herein has been obtained from sources believed to be reliable. Gartner disclaims all warranties as to the accuracy, completeness or adequacy of such information. Gartner shall have no liability for errors, omissions or inadequacies in the information contained herein or for interpretations thereof. The reader assumes sole responsibility for the selection of these materials to achieve its intended results. The opinions expressed herein are subject to change without notice