Choosing Right Niche Yields Higher CSI Margins

Transcription

1 Research Brief Choosing Right Niche Yields Higher CSI Margins Abstract: Margins are analyzed for consulting and systems integration firms categorized by similar operating models, then compared to uncover success factors that contribute to the higher margined operating models. By Martin Lee Recommendations Systems integrators pursuing a business model predicated on premium margins need to serve a specialized niche, whether it is enterprise applications, their own proprietary software system or vertical industry expertise. IT services providers should cultivate at least some niche offerings for which they can charge premium prices and boost their overall margins. Systems integrators need to be prepared for the day when their service niche is no longer as in demand and be ready with the next cycle of offerings. They need to continually refresh these premium services because of fluctuating market demand and the normal life cycle of IT services offerings. Staff augmentation companies will find their position and margins eroded as factors such as offshore outsourcing and the business services value chain take hold in the market. Staff augmentation vendors should explore ways of extending core competencies inherent in their current workforce into other services that are higher up the value chain, such as enterprise applications, their own proprietary software system or vertical industry expertise. Publication Date:October 16, 2002

2 2 Choosing Right Niche Yields Higher CSI Margins Introduction In "Profit and Loss Statement Analysis: IT Services, 2001" (ITSV-WW-DP- 0394), Gartner Dataquest examined the profit & loss (P&L) statement of 45 publicly held IT services companies. Using the same methodology, this Perspective examines the margins for a number of subcategories of the consulting and systems integration (CSI) companies for fiscal years 2000 and Please see the report noted here for the full methodology. For this Perspective, Gartner Dataquest gathered P&L statements for 31 publicly traded U.S. CSI companies for fiscal years 2000 and 2001 from public documents available from the Securities and Exchange Commission's electronic data gathering, analysis and retrieval (EDGAR) site. To calculate the margins, we added all of the P&L 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 financials for their CSI divisions; therefore, some of these figures will include a mix of other services. However, to improve comparability, we have included only companies whose top service line, in terms of revenue, is CSI. Business Trend After two years of turmoil and slackened demand, the margins for most CSI companies have taken a big hit. Is there any operating model that is in better shape than the others in terms of margin? The categories to be examined are as follows: Big Five public consultancies A CSI company with Big Five roots that is now publicly traded, such as Accenture and KPMG Consulting 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, Lante, Rare Medium, Razorfish, Viant and Zamba 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 are focused on one vertical sector, such as DAOU Systems, First Consulting Group and Superior Consultant Holdings

3 Gartner Dataquest Perspective 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 With only two public companies available, it is interesting to see whether the vaulted high margins survived going public. They appear to have done so, except at the net margin level. The gross margin for the public former Big Five consultancies rose from 2000 to 2001, from 30.8 percent to 32.2 percent (see Table 1). Despite the difficulties that most of their competitors went through in 2001, these companies improved their gross and operating margins. Unfortunately, unprofitable investments (especially on the part of Accenture) dropped the net margin. However, much of this was related to the dot-com investments made at the height of the "tech bubble," and companies have been liquidating their venture capital funds and selling out. Consequently, this exposure will have a one-time impact on the net margins. Nevertheless, the bottom line is that net margins were still positive, which is more than many other companies in this study experienced. 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 2001 (see Table 2). Gross margins were down from a stellar 43.1 percent in 2000 to 33.2 percent in 2001, a slide of 10 percentage points. This decrease was a result of the overstaffing and underutilization that plagued the industry in Moreover, nobody was buying enterprise software. In addition, operating and net margins fell by more than even the 10 percent drop in gross margins, showing that other costs were also out of line.

4 4 Choosing Right Niche Yields Higher CSI Margins Table 2 Enterprise Application Integrators' Margins, (Percent) Gross Margin Operating Margin Net Margin E-Business Integrators' Margins E-business integrators' margins were even more affected by the downturn in Gross margins fell by half in 2001 (please see Table 3). Operating and net margins declined even more. Restructuring and layoffs took a heavy toll on these vendors' bottom lines, but their ordinary operating expenses were also much too high to support their revenue level, which was a reflection of the severe overstaffing and underutilization across the organization for most e-business integrators. All the companies included here had a negative net margin. This is mainly because most had their organization prepared for 100 percent growth, and when it didn't occur, they had too many people and too little work. Some were so bad off that they actually had negative gross margins! Part of the shortfall was that the demise of many of the dot-coms had killed off one flow of spending. Concurrently, because the dot-coms were failing, the brick-and-mortar companies also held up spending because the impetus to compete faded with the dot-com failures. Also, the manufacturing sector fell into a recession about that time and held back spending. In both cases, it was the smaller CSI companies that bore the brunt of the spending cuts as companies were deciding to work with fewer service vendors and, in particular, more-experienced service vendors. 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, still leading at 42 percent in 2001 vs percent in Of course, part of the reason the margins are high is that their software is incorporated in their financial statements and is not separated out. However, these companies' fundamental structure is to provide CSI services, and the software just replaces systems development they would have done as a totally custom project. Operating and net margins did not

5 fare as well, but most of the drop for these was related to the drop in gross margins. Table 4 Integrators with Software Systems' Margins, (Percent) Gross Margin Operating Margin Net Margin Vertical Specialist Integrators' Margins The vertical specialist integrators were the only group included here to increase their gross margins more than 1 percent, raising gross margins from 28.6 percent to 35.9 percent (see Table 5). The layoffs enacted in 2000 and the retreat from unprofitable offerings helped make gross margins high again. However, high restructuring costs, a result of the layoffs, drove operating and net margins down into negative territory both years, although the overall margin situation was much better in Table 5 Vertical Specialist Integrators' Margins, (Percent) Gross Margin Operating Margin Net Margin Staff Augmentation Margins The staff augmentation companies had the lowest gross margins of all the groups here, as would have been expected given their commoditized state and the current overall glut of technical people relative to the demand. While gross margins fell by almost 1 percentage point in 2001, reflecting the heightened competition, the companies managed to tighten their other operating expenses and greatly reduce the losses incurred in 2000 (see Table 6). Another factor that greatly affected this industry has been the offshore service providers. With costs that are half or even less that of most domestic staff augmentation companies, even with reduced pricing at 70 percent to 80 percent of regular pricing, these offshore service providers still had very high margins. Table 6 Staff Augmentation Companies' Margins, (Percent) Gross Margin Operating Margin Net Margin

6 6 Choosing Right Niche Yields Higher CSI Margins Application Development and Management Outsourcing Margins Why is an IT management services company being examined here? 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 were slightly higher than that for the staff augmentation companies, reflecting their focus on higher-margin services. Furthermore, the application development and management outsourcing companies were one of a few of the groups to actually raise gross margins. They pumped up gross margins from 30 percent in 2000 to 31.2 percent in 2001 (see Table 7). This rise was matched by a similar rise in operating and net margins. However, the overall gross margins are not much higher than those for the staff augmentation companies. Table 7 Application Development and Management Outsourcing Companies' Margins, (Percent) Gross Margin Operating Margin Net Margin Table 8 Comparison of Margins, 2001 (Percent) 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 21 percent to 42 percent, except for extraordinary circumstances like that encountered by the e-business integrators in The groups most dependent on e-business services had much worse gross, operating and net margins than they did in 2000 because of the severe drop in demand for their services. Gross Margin Operating Margin Net Margin Integrators With Software Systems Vertical Specialist Integrators Enterprise Application Integrators Big Five Public Consultancies Application Development and Management Outsourcing Companies Staff Augmentation Companies E-Business Integrators

7 7 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 enterprise application integrators. The two with the greatest below-average gross margins were staff augmentation companies and e-business integrators. Integrators with software systems had the highest gross margins by a wide margin with 42 percent. Vertical specialist integrators had the second highest at 35.9 percent, followed by enterprise application integrators at 33.2 percent and the Big Five public consultancies at 32.2 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 10.3 percent, followed by application development and management outsourcing companies at 5.2 percent and integrators with software systems at 2.5 percent. Application development and management outsourcing companies had the highest net margin at 4 percent, followed by the Big Five public consultancies at 1.5 percent and integrators with software systems at negative 0.2 percent. Gartner Dataquest Recommendations The wide gap between the above-average groups and the below-average groups represents the premium of having a specialized niche in demand that the vendors can exploit, whether it is enterprise applications, their own proprietary software system or vertical industry expertise. It also demonstrates how quickly fortunes can change: E- business integrators watched their gross margins collapse from 43.6 percent to 21.1 percent as they desperately tried to reduce their head count in the face of plummeting demand. Companies need to be better aware of when the demand for their services is going to change, for better or for worse. In addition, staff augmentation companies will find themselves reaching a fork in the road as well. Offshore outsourcing has been taking away some of their business. Their presence has increased competition and decreased the staff augmentation companies' margins. Also, when the business services value chain falls into place, the business solution aggregator will have the relationship with the account. (For a detailed explanation of the framework, please reference "The Services Value Chain: Forging the Links of Services and Sourcing" [AV ] and "The Services Value Chain Provides Framework for Joint Ventures" [AV ].) This will place staff augmentation companies further down the value chain and cut off contact with their end-user clients, further weakening their position and margins.

8 8 Choosing Right Niche Yields Higher CSI Margins One way to use the account contact and sales channel that staff augmentation companies currently have would be to expand into other services. Many companies have successfully added services. Keane and Syntel are the most successful so far; another service line now comprises more than 50 percent of their revenue. Ciber is close behind them; staff augmentation represents less than 50 percent of its revenue, though it is still the company's largest service segment. Last, the high margins that the integrators with software systems have illustrate the value of creating a niche area of expertise. By cultivating at least some niche offering such as their own software system, enterpriseapplications or vertical industry expertise CSI companies can charge premium prices and boost their overall margins. In addition, the integrators with software systems operating model allows the company to develop a repeatable solution that will help reduce overall costs for the CSI company and boost margins even further. Key Business 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-0402 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 2002 Gartner, Inc. 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