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Will Outsourcing Still Fly?

EDS's financial troubles have raised questions about outsourcing deals, but the answers are mostly upbeat.

Last fall, the outsourcing industry seemed poised for a tailspin. Drained by soured bets on its own stock, a drop-off in new business, and a crop of troubled existing customers (including the bankrupt US Airways and WorldCom), Plano, Texas-based outsourcing giant EDS Corp. shocked Wall Street with its announcement that it would miss earnings targets. Those troubles, combined with a credit-rating downgrade, meant it might become harder for EDS to get the cash needed to maintain operations for customers. And that prospect led some to speculate that outsourcing deals in general would no longer be as sweet as they once were.

“The market has seen what can happen when deals are unfavorable to the outsourcers, and companies will likely think long and hard about being aggressive in their negotiations,” one analyst who follows EDS and other major outsourcers told CFO at the time. That EDS was renegotiating some of its worst-performing contracts, like the $6.9 billion U.S. Navy agreement, only heightened the expectation that outsourcing could get more expensive.

But a quarter later, consultants say EDS’s financial problems have had little effect on the deals struck by outsourcing clients for IT services such as data networks, servers, and storage. Instead, they say, customers are continuing to wield their buying power for all it’s worth. “I’ve seen some of my clients ask for things that would have been ridiculous two years ago,” says Plano, Texas-based Bob Pryor, head of Cap Gemini Ernst & Young’s outsourcing consulting practice in North America. And just because a contract isn’t set to expire is no reason not to renegotiate it. “About one-third of our business is renegotiating arrangements signed between 1998 and 2001, when rates were higher, demand was stronger, and service providers had more control,” says George Casey, head of the outsourcing consulting division of Washington, D.C.-based Shaw Pittman LLP, a law firm that specializes in outsourcing contracts. “Now that [companies are] finding they signed up for more volume than they needed at higher rates, we’re trying to bring [their contracts] back in line.”

Costs for major components of IT infrastructure management have indeed gone down. And in one of the most promising advances, outsourcers like EDS, IBM, and Hewlett-Packard are developing ways to share equipment among clients more efficiently, allowing them to reap greater economies of scale and demand fewer volume commitments from their customers.

“The notion that you pay for everything, whether you use it or not, will fade,” predicts John Lutz, managing director for the financial-services sector at IBM Corp. Instead, “there’s been a real emphasis lately on not just cutting costs, but making them more visible, and more able to scale up and down as business volumes fluctuate.”

This pay-as-you-go, utility-like approach was a key feature in the $5 billion, seven-year deal IBM recently inked with JPMorgan Chase for IT and business-process services, as well as in deals with American Express and Deutsche Bank, Lutz says. He expects the approach to become an industry standard going forward — despite the risk it poses to IBM’s revenues. “This is a balanced risk that we’re delighted to take,” he says, “because the last thing you want in any contract is something that causes you to drift away from the customer.”

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