IT OUTSOURCING & MANAGED SERVICES A TripleTree Industry Analysis
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TABLE OF CONTENTS INTRODUCTION
3
TRADITIONAL IT / INFRASTRUCTURE OUTSOURCING
4
Tier 1 vs. Tier 2 Outsourcers Diminishing Mainframe Assets and Future Challenges
5 8
EMERGING BUSINESS MODELS AND GROWTH OPPORTUNITIES
9
Managed Hosting Application Outsourcing & Cracking the Middle Market
9 10
Remote Application Infrastructure
14
Special Insert - Perspective from IBM
15
Managed Security
18
Growth Drivers Competitive Landscape Market Opportunities
18 20 22
THE IMPACT OF BPO AND TRANSFORMATIONAL OUTSOURCING
23
Global Sourcing and the Role of Offshore Service Providers
28
Mergers & Acquisitions Public Markets
28 30
CONCLUSION
33
TRIPLETREE’S BPO/OUTSOURCING TEAM
34
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M & A PUBLIC MARKET ACTIVITY AND VALUATIONS
25
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INTRODUCTION Over the past seven years TripleTree, LLC (www.triple-tree.com) has published twenty eight white papers and a number of shorter executive series reports that have covered numerous topics within the IT, outsourcing, healthcare, business services and software sectors. Among these have been two major pieces (see "Trends in Outsourcing," July 2001 and "2003 Outsourcing Update," March 2003) specifically devoted to "outsourcing," as well as three major papers on application outsourcing (see "ASP Spotlight Report," September 1999, "2nd Generation ASPs," September 2000, and "Software as a Service: Changing the Paradigm of the Software Industry," September 2004). As we enter the second half of 2005, the relevance of outsourcing continues to increase as outsourcing businesses of all types continue to grow and permeate the competitive landscape across a number of sectors. Where in the mid to late 1990's most people's understanding of outsourcing was limited to large platform outsourcers such as IBM and obvious examples of transaction processors such as ADP or Fiserv, today the variety and complexity of different outsourced service offerings has exploded. A myriad of offshore offerings have become realities, many software companies are adopting "services-based" pricing and delivery of their products, and numerous vertical industries continue to witness the splintering of business processes into discrete components that can be farmed out to emerging business process outsourcing ("BPO") companies. All of this has caused us to update our outsourcing research. Our goal in this report is to revisit traditional IT outsourcing with a bend towards incorporating a fresh view of many of the emerging opportunities in the middle market and within a range of emerging managed services sectors. We will follow this report in a number of weeks with another report that will take a deep look into outsourcing in the healthcare industry - with particular focus on the revenue cycle and claims administration sectors.
Consistent with past practice, we have invested considerable time interviewing the CEOs of approximately 40 of the roughly 250 relevant private managed services companies we follow to gain a first-hand perspective of how the themes discussed in this report are impacting their businesses. By combining broad-based industry updates with the attributes of emerging growth companies, we have attempted to put into context the state of competitive play from a vantage point that will benefit business operators, investors, and others who are involved in building meaningful companies in the outsourcing market.
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We have also dedicated a section of this report to the offshore phenomenon, where the melding of BPO and ITO offerings from India, China, Russia, and other frequently referenced offshore locations is impacting the manner in which IT outsourcing services are procured here in the United States. Although the impact will vary from sector to sector, the convergence of offshore labor arbitrage with other technology enabled service offerings is a common theme that surfaces throughout our analysis.
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TRADITIONAL IT / INFRASTRUCTURE OUTSOURCING Figure 1: U.S. IT Outsourcing Projected Growth 2003-2008
U.S. IT Outsourcing Projected Growth 2003-2008 $45,000
$42,323 $40,658 $38,882
$40,000
$36,967 $ 3 4 ,8 9 6
$35,000
($ M illion s)
Before launching into an analysis of emerging managed services businesses, it is helpful to cover some foundational data relative to the state of affairs for traditional IT outsourcing companies - which we refer to as "platform outsourcers" or "infrastructure outsourcers." According to IDC, the traditional U.S. IT outsourcing market continues to grow at a moderate pace with an anticipated CAGR of 5.3% from 2003-2008. Despite this steady growth, there are a number of trends that point to the continued commoditization of basic infrastructure outsourcing and ultimately to a need for traditional leaders in this market to evolve their business models to combat pricing pressure and maintain profit margins.
$32,687
$30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0S 2003A
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Perhaps the most pervasive trend impacting platform outsourcing companies is a steady drive to reduce the cost of data center operations. Continued advancements in data center automation software and tools, migration away from mainframe computing, as well as extensive server consolidation, have continued to reduce the level of staff required to manage the infrastructure of large customers who have traditionally outsourced all, or major components, of their IT environment to mainstream outsourcers such as IBM, CSC, EDS, HP, Unisys, and Perot Systems. These improvements in productivity are reflected in much of the research on the topic including a fairly comprehensive set of staff productivity statistics that were released in 2004 by what was then The Meta Group. (The Meta Group was acquired by Garnter, Inc., April 2005.)
2004E
2005E
2006E
2007E
Source: IDC
Notably, the Meta Group statistics were collected from a wide array of companies, many of which did not outsource their IT departments. As a result, the staff productivity ratios illustrated below, while showing strong increases in productivity, are still not indicative of efficiency gains realized by companies described as complying with "best practices." For obvious reasons, companies that provide IT outsourcing services fall into this "best practices" category - but some would argue that the efficiency/cost savings advantage offered by outsourcing companies is falling under continued pressure. The decreased staffing requirements and increased level of automation reported by the Meta Group point towards commoditization, continued price pressure, and the need to build large economies of scale in order to drive favorable profit margins.
Figure 2: U.S. IT Outsourcing Projected Growth 2003-2008 Mainframe Productivity / Staff (FTEs) per MIPS
0.1600 0.2484
0.2500
1. 0 0 0 0
1.0000
0.2267 0.1974
0.2000
0.8000
0.1938
0 . 2 5 13
0.2067
0.2000
0.0500 0.0000
S
1997
1999
2001
2003
0.1336 0.1179 0.0991 0.0858
0.0600 0.0400
0.1000
0 .3 8 0 9
0.4000
0.1400 0.1200 0.1000 0.0800
0.1500
0.6000
0.0000
Intel Staff (FTEs) per Processor
Unix Staff (FTEs) per Processor 0.3000
1.2000
0.0200 S 0.0000
S
2000
2001
2002
2003
2000
2001
Source: Meta Group MINNEAPOLIS 952.253.5300
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Figure 3: Tier 1 Market Share
Tier 1 Market Share
Revenue ($Millions)
Market Share
5,897 5,159 2,166 1,327 956 594 580 565 451 275 17,970
18.0% 15.8% 6.6% 4.1% 2.9% 1.8% 1.8% 1.7% 1.4% 0.8% 55.0%
Tier-2 & Other
14,717
45.0%
Total
32,687
100.0%
IBM EDS CSC Northrop Grumman ACS HP SAIC Lockheed Martin Perot Systems Unisys Subs-total
10 “Tier-1” IT outsourcing companies control 55% of the U.S. market.
Source: IDC, 2004
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“ T I E R - 1 ” VS . “ T I E R 2 ” O U T S O U R C E R S While the above trends have had an impact across the entire platform outsourcing landscape, it is useful to segment outsourcing providers into different groups in order to better understand how they are attempting to build sustainable businesses. We find it useful to split the landscape of outsourcing companies into "Tier-1" and "Tier-2" providers. The Tier-1 companies consist of a short list of household name companies that have dominated the IT outsourcing sector for many years. Tier 1 outsourcers focus primarily on "enterprise level" accounts, generally described as the Fortune 500, where customers have made the decision to outsource all, or nearly all, of their infrastructure management to a strategic outsourcing partner. Although some of the "Tier-1" providers are claiming to come down stream into the Global 2000 and middlemarket sectors, historically the general landscape has played out as presented in the diagram on page 6. Although the lines of demarcation have blurred to a certain extent, the competitive landscape for infrastructure outsourcing is currently characterized by the ability of competitors to adapt their goto-market and services delivery capabilities to widely divergent customer requirements that impact contract size, length and complexity. The Tier-1 competitors are very adept at chasing and delivering very large ($50M-$1B+) contracts. In addition
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A common strategy employed by platform outsourcers to combat customers' requirement to drive down IT costs has been the introduction of "utilitybased" or "on-demand" pricing for infrastructure services. The concept here is that the customer can procure additional infrastructure services on an "asneeded" basis, and thereby avoid fixed payments for infrastructure capacity that may not be required. Although this strategy on its surface makes terrific sense, most customers have found that their hardware/infrastructure costs are a relatively small component of the overall cost of managing their entire IT environment. Most have found that the cost of managing their mission critical applications runs 2.0x-6.0x as high as managing their infrastructure. As a result, the "utility" computing concept, in so far as it focuses purely on infrastructure, only addresses a small part of the problem. In response, many of the traditional platform outsourcers are moving headlong into managed application services (i.e. IBM acquisition of Corio & ACS acquisition of Bluestar) where they can expand their ROI advantage to incorporate a broader cross section of overall IT costs. While the migration to higher value added services, such as managed ERP services, will help combat commoditization of traditional infrastructure, we would note that the vast majority of platform outsourcing companies still focus the bulk of their services on infrastructure management.
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to offering infrastructure outsourcing services, they frequently are able to offer attractive financing by acquiring their customers' hardware and leasing it back to them over the life of the outsourcing contract. While the bulk and financial strength required to pursue these large contracts creates significant barriers of entry for would-be competitors, the growth prospects are somewhat limited by the fact that the high-end of the market is mature. All of the attention paid to the fortune 500 market by the Tier-1 players has created a relative void in the market for smaller "Tier-2" opportunities. Tier-2 customers generally have IT outsourcing needs that equate to contracts with annual values ranging from $250,000$500,000 on the low-end to upwards of $10-$15 million per year on the high end. The smaller contracts are sometimes indicative of smaller customers, or in many cases, are the result of "selective outsourcing." The term "selective outsourcing" was coined by a few industry analysts over the past few years and refers to situations where a large customer does not want to outsource IT in its entirety but would rather engage in a targeted, well defined outsourcing arrangement that is generally perceived by the customer as less risky. Sometimes the contracts are
tied to a specific business unit within a much larger organization, other times only certain components of IT are sent to the outsourcer. The perceived benefits for the customer include: • Customer maintains ultimate control over IT • Outsourcer becomes an extension of internal IT rather than a replacement • Greater flexibility to outsourcing relationship • Predictable savings/results and less risk than handing over all IT requirements to an outsourcing partner. While the obvious benefits for customers have created reasonably strong demand for "selective outsourcing," the Tier-1competitors have traditionally not been as adept in focusing their business models to secure market share in this lower tier of the market. As a result, a handful of Tier-2 players have emerged to take advantage of these opportunities that seemingly arise below the radar screens of their larger Tier-1 competitors.
Figure 4: Traditional Infrastructure Landscape
1st Tier:
PAGE 6, IT OUTSOURCING & MANAGED SERVICES
Perot CSC CGI
IBM EDS HP
2nd Tier: Infocrossing iStructure (Technology Spectrum) Acxiom Sungard (Numerous subsidiaries)
•
Contracts into the $1+ billion range
•
Acquire hardware & lease back to customers
•
Contracts with $500K$10M annual values
•
Customers own majority of hardware
•
Positioned as alternative to “Tier 1” providers
Fortune 500 to Global 1000
• • •
•
Middle Market to Global 1000
• • •
Continue to battle for large accounts Bundled service, technology, software offerings Certain players move into BPO
“Selective” outsourcing & emerging managed services offerings Move into certain verticals such as health care Consider move into certain areas of BPO Possibly find the right acquisition platforms to more effectively penetrate the midmarket
Source: TripleTree Research MINNEAPOLIS 952.253.5300
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We should note that the selective outsourcing strategy employed by many Tier-2 players also has a potential downside for the outsourcer - multi-sourcing. While discrete and flexible outsourcing arrangements may endear the outsourcer to customers and create new revenue opportunities, this approach also enables the customer to engage the services of multiple outsourcers that are willing to play the selective outsourcing game. Many customers that have experience with outsourcing have become sophisticated enough to manage multiple outsourcing partners as a means of selecting best-of-breed services and generating price competition between competing providers. In addition to fostering price pressure during contract renewals, multi-sourced accounts also create challenges for account stability and customer retention. Perhaps the highest profile Tier-2 player is Infocrossing (NASDAQ:IFOX), one of the few Tier-2 players with a national foot-print as depicted in the following diagram: Figure 5: Example of Tier 2 Player
Depth of Solutions Offering
Enterprise Based
Tier-1
Acxion iStructure SunGuard
INFOCROSSING
IBM HP EDS Perot CSC CGI IBM
Handful of others including several subsidiaries of insurance, financial services, and other non-IT companies
While iStructure and the other Tier-2 competitors serve customers nation-wide, IFOX is the only Tier-2 player with a data center on both the east and west coast
Tier-2 Hosting Based Local / Regional Data Center Footprint
NATIONAL Data Center Footprint
Global Data Center Footprint
Infocrossing, along with iStructure (possibly Technology Spectrum if the company is brought public), Axciom, and SunGuard are the most frequently cited Tier-2 competitors. There are a handful of other private companies as well as a few subsidiaries of large insurance companies, financial services firms, and operating companies that also compete at the Tier-2 level. Although most of these companies serve customers nationally, most will confess that a limiting factor for revenue growth stems from potential customers' fear of locating their IT environments MINNEAPOLIS 952.253.5300
too far away from home. As a result, with the exception of Infocrossing (that has a national footprint), many of the Tier-2 companies have seen their growth somewhat limited to the geographic regions in which their data centers are located. The firms in this sector have a fairly heavy concentration of mainframe business, but are seeing much of their growth coming in the AS/400/mid-range server and open system server environments. Although business models
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Source: TripleTree Research
SEPTEMBER 2005
vary among the different competitors, many of the Tier-2 customers maintain ownership of the outsourced hardware and systems and physically move their servers to the outsourcer's data center where the following services are performed: • System management/monitoring; • Tape and storage management; • Batch processing; • Network management; • Print and report distribution. In other words, the Tier-2 providers are performing much of the same services as their Tier-1 counterparts, with the distinction that they are managing smaller more flexible contracts where the customer frequently retains ownership of the IT hardware and software systems that are relocated to the outsourcer's data center. The business models of the Tier-2 companies are still highly focused on infrastructure management, with high levels of operating leverage and margin driven by economies of scale developed around selected server environments. As their businesses grow, they are able to leverage resources - such as NT administrators, Unix administrators, network administrators, shared storage, and support center personnel - across multiple clients.
DIMINISHING MAINFRAME ASSETS AND FUTURE CHALLENGES
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Our view is that the next 2-3 years will force a fundamental shift in go-to-market and services delivery models for all of the leading Tier-1 and Tier-2 platform outsourcers. The ultimate winners in this sector will overcome a host of challenges including the following:
• Overcome price pressure and commoditization of infra-
• Scheduling services; and
The majority of the platform outsourcers currently suffer from an over-abundance of mainframe business. Mainframe contracts are terrific in the sense that they tend to be large and profitable, but they unfortunately are a diminishing opportunity as most customers are rushing to newer, less expensive, open systems environments. The challenge here is that customers that engage a "selective" outsourcer don't necessarily have any plans of outsourcing their open systems environment once they ultimately say good-bye to their mainframes. As a result, essentially all of the platform outsourcers are somewhat growth challenged as they seek to replace large mainframe contracts with multiple, and smaller, open systems contracts from multiple new customers that may, or may not, have experience utilizing an outsourcing partner. We expect a fair amount of new business activity will MINNEAPOLIS 952.253.5300
likely only have limited impact on top-line growth for many of these companies over the next 1-2 years as they slowly shift their business mix.
structure services. Traditional infrastructure outsourcing customers are notorious for hammering down price when long-term contracts come up for renewal. We expect this trend will continue - and likely intensify;
• Migrate services capabilities "up the services stack" to include application management and other noncommodity-based functions;
• Survive challenge of migrating revenue stream away from legacy mainframe business into higher growth areas including open systems;
• Enter new markets including going downstream into the middle market and a potential focus on particular vertical industries such as health care, financial services, and others;
• Contend with a large number of emerging managed services companies that are described in the following section of this report; and
• Contend with a steady trend towards global sourcing, also discussed below, where intermingling of business process outsourcing and IT outsourcing from both near-shore and off-shore locations has the potential to dramatically impact pricing dynamics for the industry. The above operational and competitive challenges will also likely be colored by continued consolidation among various industry participants. While the number of potential acquisitions among the Tier-1 and Tier-2 competitors is somewhat restrained by the relatively small number of companies, we expect that a limited amount of consolidation is still likely to occur, and although the deal activity will be somewhat limited, the transactions that do take place will probably have meaningful consequences for the competitive landscape.
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EMERGING BUSINESS MODELS AND GROWTH OPPORTUNITIES Although the competitive landscape among the Tier-1 and Tier-2 companies is fairly well cast at this point, it is important to note that the majority of their business is focused heavily on infrastructure management in the realm of mainframe and mid-range computing - although we admit that certain players have begun to launch successfully into the open systems sector. Few of these companies have had significant success moving up stream to capture higher value added services such as application management or managed security, nor have their efforts in the open systems sector resulted in the creation of dominant managed hosting businesses. As a result, there are a range of emerging companies that are taking advantage of growth opportunities, which in contrast to traditional platform outsourcing, are still relatively immature with room for new entrants and the creation of niche market leaders.
through 2005, several of the managed hosting companies that weathered the storm have made meaningful changes to their business models that have improved pricing and enabled them to secure and retain meaningful client footprints. Central to the improved performance of these companies has been their migration away from facilities based, or what some analysts refer to as "co-location plus," services with an eye towards offering a range of higher value added services to support and manage an application environment. Many of the firms in this sector have coined different terms for these services such as "intensive hosting" or "on-demand systems infrastructure." Others have taken the strategy one step further by concentrating heavily on the Microsoft or Linux platforms. The segmentation of services within the overall managed services stack is presented in the diagram below.
MANAGED HOSTING We admit that traditional managed web hosting is a commodity business, and that the sector's reputation was marred for much of 2002-2003 by weak client demand and significant service provider instability. However, during 2004 and continuing
The systems level focus of many of the emerging managed hosting companies is distinct from the co-location or infrastructure providers, who focus on access & connectivity, and the application outsourcers who manage end-user functionality. Their strategy exploits the fact that many end-user
Figure 6: Managed Services Stack
Applications (ERP,CRM,SCM,other Enterprise Apps)
Systems Proprietary Tools / Processes Operating Systems
Data Base
Load Balancing
Firewall/Network Security
Storage, Monitoring/Reporting, Back-up
Infrastructure (Bandwidth/Access/Hardware/Physical Facilities)
Database and operating system management Storage Security (physical and data) Bandwidth Monitoring and reporting Load balancing Data back-up Vaulting Network Devices Messaging
Sources of Operating Leverage: Economies of scale on specific platforms (i.e. Microsoft/Linux/Unix) Automated tools/systems Shared infrastructure Proprietary service methodologies
Source: TripleTree Research MINNEAPOLIS 952.253.5300
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Application Infrastructure (Middleware / Application Integration)
Many managed hosting companies emphasize “systems management” expertise: Services Provided:
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customers, as well as many software vendors who are invoking the Software as a Service (SaaS) business model, are not well equipped to optimize and manage the systems environment in which their end-user applications function. Ultimately, application performance is driven to a large degree by optimizing the systems environment in which the application functions. Most of the co-location or hosting companies (historical examples include Exodus, Cable & Wireless, and many others) do not adequately service this need. Meanwhile, many customers who want to move their servers off site (and whom frequently would have selected a co-lo partner) also want to maintain control of the "application." The emerging managed hosting companies are filling the void between these two dynamics while providing a higher-valued service than their co-location counterparts which has enabled them to improve pricing and profitability. This strategy is working for several higher profile private companies such as Rackspace and Vericenter (recent acquirer of Agiliti), as well as a number of very large companies, such as IBM, AT&T, MCI, and Savvis, that also offer managed hosting solutions. One of the more encouraging signs in the managed hosting sector is the surprising survival of numerous relatively small regional competitors that focus on small to medium (SMB)
customers. While the conventional wisdom over the past 2-3 years has been that managed hosting companies need to scale well north of $20M in revenue before generating meaningful profits, we now know that there are several regionally focused companies with less than $20M in revenue that are generating healthy profits.
A P P L I C A T I O N O U T S O U R C I N G & C R A C KING THE MIDDLE MARKET According to IDC, the US application management services market is expected to grow at a 6.9% CAGR from 2004-2009 reaching nearly $12 billion in size. It is important to note that IDC includes outsourced application maintenance within its definition of application management. Application maintenance services are frequently focused on legacy systems and are among the most frequently cited services that are shipped to off-shore companies such as Wipro and Cognizant Technology Solutions. These application maintenance services should be distinguished from application hosting - or the businesses that were once frequently referred to as application service providers - or ASPs. The trend with application hosting companies is somewhat similar to that of the managed hosting companies described below.
Figure 7: US Application Management Services Spending 2004-2009 US Application Management Services Spending 2004-2009 (in $millions) $11,870 PAGE 10, IT OUTSOURCING & MANAGED SERVICES
$11,264
$12,000
$10,599 $9,173
$9,892
$8,488
$10,000 $8,000 $6,000 $4,000 $2,000 $-
2004
Source: IDC
2005
2006
2007
2008
2009
Application Management Services
Source: IDC MINNEAPOLIS 952.253.5300
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During the late 1990's and into 2001, there were several high profile ASPs that made a big splash in the market but were then unable to drive meaningful profits. In addition to problems with their core business models, most of the ASPs then hit the wall during the recessionary period of 2002-2003 due to significant drop off in customer demand. Over the past 18 months a few of the survivors have been acquired (Corio by IBM, Bluestar by ACS, Surebridge by Navisite). While the consolidation of these well known companies signaled to some the end of the ASP era, our view is that these transactions actually validate the fact that a few of these companies were able to evolve sustainable business models. While the concept of a "one-to-many" application service business seems like a hold-over from the Internet bubble, a number of the core tenants of the model have been validated - including the central premise that the ongoing cost and challenge of application management far exceeds the cost of the initial software license and implementation. This is especially true for companies with less than $2 billion in revenue. Well over 50% of the companies with $50M-$2B in revenue responded that the ongoing cost to main-
tain their critical applications exceeded their initial license fees by 2x-5x. It's not surprising to see these statistics reported among middle market companies who, despite their relatively small size, often have very complex business processes that drive significant software management requirements. This challenge is exacerbated by the fact that most middle market companies have comparatively small IT staffs relative to their Global 1000 counterparts. These dynamics would seemingly point to a very large application outsourcing opportunity in the middle market. Some analysts have estimated that in the U.S. alone, there are 30,000-40,000 businesses with annual revenue ranging from $50M-$2 billion. Others have estimated that 30% or more of these companies have implemented an ERP system or similar enterprise software license. This seemingly target-rich environment, coupled with the fact that most of the traditional Tier-1 and Tier-2 infrastructure outsourcing companies are fishing "up-stream" for bigger contracts, continues to attract emerging companies seeking to build a true market leader in the middle-market application management sector. Although this certainly isn't a new idea, there have been some recent variations in terms of the best go-to-market and operating models employed to capture the opportunity.
Application Management Expenses for Companies with Revenue Ranging from 5x software purchase price Don’t know
19.8% 12.3% 25.3% 8.3% 8.3% 26.1%
Companies w/ Rev $50M-$500M 11.6% 7.0% 36.1% 17.5% 5.8% 22.1%
Companies w/ Rev $500M - $2B 8.8% 5.3% 28.1% 19.3% 14.0% 24.6%
Source: IDC MINNEAPOLIS 952.253.5300
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Companies w/ Rev
