IT Services Markets Crumble~Driving Detroit’s Rut

IT Services Markets by Tony Greenberg and Alex Veytsel / RampRate Blog here

Is the Media Business Next?

Media firms have been my clients for years. Most IT firms complain the media firms prey on IT services firms by offering to “reference them” for larger enterprise deals. WRONG. Media firms, much like adult entertainment firms are the spaghetti slingers and early adopters of new tech.  You have to love them for taking the arrows in the back and mounting themselves on the fireplace alter as trophies.

Media firms are actually IT Heroes. While banks and automakers wax excel poetic about risk and return on investment; Disney, ABC, News Corp., Viacom, CBS and Sony — all past or current clients — pave the yellow brick road. Hats off to you all for “boldly going where no man has gone before.” For now, let’s ponder what lessons we can learn from the carnage of auto and the future demise of IT.

A couple of months ago we posted a bold proposition – that the U.S. IT services industry, while nominally healthy today, could find itself following the same ditch-bound trajectory as the U.S. auto industry. Such a bold claim requires significant evidence, so to start; we’d like to focus on four ways in which the parallels are beginning to emerge:

1. Consolidation – an early enabler rather than driver of failure, it creates an atmosphere where mistakes are magnified
2. Misalignment of incentives for quality and innovation tied to scale – as companies get larger, they focus more on cost cutting than creative destruction and product innovation
3. A shielded class of workers – unions for Detroit, salespeople for IT services – create a significant financial overhead  and contribute internal pressure towards conservatism
4. Calculated failure – whereas early service issues ultimately come from an inability to effectively predict and remedy problems, later ones are deliberate tradeoffs of service quality for cost.

The next several posts will focus on specific tactical drivers of stagnation and ways it can be reversed. In speaking at Humanity + at Harvard in June, I  overviewed how capital markets reward poor service: www.boilthehuman.com. As this article is focused on IT, I want you to start thinking of the media business and how this relates.

Is this the beginning of the demise of an industry so critical to our gross national product and evolving state?

Consolidation

When an industry is consolidated in the hands of a few decision makers, groupthink will prevail and collective mistakes will be made. They will initially use economies of scale to drive efficiency, but then stagnate under the weight of the same scale. Is this akin to the media business? Ought we think about the parallels of destruction?
The auto industry has consolidated early on, from hundreds of providers at the turn of the 20th century to the Big Three and a small number of hangers – on fifty years later. While the IT services industry as a whole has thousands of companies, it is also moving down the path of consolidation. To give some examples:

1. The data center industry has seen two large 2010 consolidation moves with Equinix buying Switch & Data on the Internet Exchange side, and Digital Realty Trust snapping up 365 Main’s data centers in the wholesale segment.
2. Gartner’s Eric Goodness could name only one Remote Infrastructure Management provider of note that hasn’t been absorbed by a larger IT services firm.
3. Telecom has the early lead as the largest M&A industry in 2010

Consolidation is not bad in itself. The car industry reached its heyday with an oligopoly.  However, it sets the stage for future issues by creating risk aversion and reducing nimbleness, and that is what we are starting to see in IT services.

Misalignment of Incentives for Quality and Innovation
One of the long-standing controversies in economics is the Schumpeterian hypothesis that more concentrated industries promote product innovation (better quality to the end-customer) or process innovation (lower costs to the producer). Recent research from 2008 seems to show that there is some product innovation benefit to concentration in purely quality-driven industries.  However, the researchers found that “product R&D expenditure decreases with market share when the perceived quality relative to price determines the market shares of firms.”

IT services is indeed driven by price-quality tradeoffs. As the industry gets more consolidated, innovation in product/service quality is reduced, while the focus becomes process innovation which for practical purposes amounts to cost-cutting.  Our experience in the market is starting to show anecdotal evidence of this.  The largest providers are often the ones with low-density data centers and heavier users of labor arbitrage than automation in managed services. As with consolidation, it’s not a full-blown, clear-cut, one-way trend. Upgrades to 10Gbps networks took hold in large IP transit providers faster than their smaller peers, and the largest providers build or buy significant portfolios of value-added services in markets like CDN. And to be fair, along with tail fins and tank-like SUVs, cars have gotten safer over the years – a ten-fold reduction per mile driven since 1937.

But true “creative destruction” (Schumpeter’s better known concept) rarely takes hold in companies with a lot to lose. That is why it takes a relative outsider (Amazon) or a smaller provider (Rackspace, Terremark), rather than a top-three data center or managed hosting firm to mass-market a big change like cloud computing.  It’s why we’ve seen larger data center companies walk away from deals based on an install timeline or density just outside their comfort zone when smaller vendors paid an electrician some overtime and came up with patchwork solution on the fly to meet client needs. And it may be the reason why we don’t have a flying car — when you have nothing to lose, you are more likely to support revolutions.  When your investors expect a steady revenue stream, you invest in evolution.

A Shielded Class of Workers
Internal pressures from influential employee populations also lead to increased conservatism. While any discussion of UAW’s role in Detroit’s troubles is bound to provoke a storm of partisan controversy, the final calculus is that labor and management collectively reduced the size of the revenue pie.  They did this in part through the way they divided it, both in the energy spent on fighting the battle and the limitations on flexibility that emerged from it. In the IT services world, there is no major union activity.

Nevertheless, there is a protected class of worker that holds the keys to the castle, and that class is the sales organization.  Now it might be odd to compare sales which has some of the highest turnover in the company to the tenured positions of unionized workers.  However, the sales organization has almost limitless power to make or break a company’s quarterly results, and fights fiercely for the status quo and its commissions.

Even as costs are cut throughout IT services, sales commissions remain relatively unchanged at around 10 percent for a direct rep, with additional overlays for managers. Non-salaried and external referrers can get even more. More importantly, behind the scenes, compensation structures shape a large portion of deals, even when neither the buyer nor the seller’s employer benefits. This constant struggle to hire, retain, and properly incent sales becomes as much a focus for IT services providers as union relations for GM or Ford.

The lack of ability or desire to effectively understand and promote new and innovative solutions within the IT services sales force is something that we and other industry insiders like Phil Fersht encounter every day. It rarely makes it into public view. Among other things, we’ve seen salespeople give short shrift to cloud solutions because they wouldn’t be part of the transaction in the long term – an echo of the UAW joining the Big Three in fighting improved gas mileage targets in 1990.

Calculated Failure
Deliberate compromising of car safety for other attributes, whether visual appeal or cost reduction, is the centerpiece of Unsafe at Any Speed, which launched Ralph Nader’s rise to prominence.  Against a backdrop of generally improving car safety, these tradeoffs were not necessarily statistically noticeable. But they were sure as heck noticeable to Corvair customers that were in just the right type of accident.

In the IT services industry, the situation is similarly complex.  Overall customer satisfaction is rising, and buyers are planning to do more outsourcing, in large part because product innovation is improving uptime and removing accidental errors.  However, process innovation, focused on cost cutting,  is pushing service providers in the opposite direction and limiting the potential.

From a quantitative perspective, our recent private evaluations of help desk support in internal service organizations, as well as a 2008 MIT study, show how support migration to lower-cost external providers (not just offshore) reduced customer satisfaction.

Moreover, the savings achieved most frequently went into the organization’s pocket rather than product improvements, failing to compensate the end user.

Anecdotally, the situation appears to extend to companies that did not migrate their support structure externally.  Multiple providers that used to have a “make it right” fund for unhappy customers or adapted their policies as needed to sensibly handle a situation, are now becoming more rigid and cost-driven.  For example, if a customer missed a deadline to cancel an auto-renewal even by one day, they would refuse to negotiate without a huge fight. So whereas the SPY Index used to have dings against providers for accidental failures before, it is now more and more full of cautionary notes for deliberate, calculated short-term profit seeking at the expense of long-term relationship health.

Starting the Path to Stagnation
The state of the IT services industry is nowhere near a full-scale decline. Technical innovation still proceeds apace, with virtualization becoming mainstream, data center densities in excess of 10x the conventional limits being deployed, and autonomic agents not just notifying users of faults, but going through resolution processes automatically and then reporting the results.

IT Services Markets

However, the fundamental structures supporting this evolution are starting to crack. Fewer, larger, more risk adverse companies are refocusing on cost cutting and using M&A instead of R&D to gain market share. In a world of automated provisioning and support, sales remain a human-scale process that at worst actively sabotages and at best fails to support change.  And even as unintentional downtime is decreased by technical improvements, service level faults related to deliberate cost-control decisions are taking their place.

These are all macro trends, so what can we as buyers, sellers, and mediators of the IT services industry do? We will offer some of our suggestions in an upcoming series of posts on IT industry myths that are holding back each of the parties from taking tactical steps to improvement.  But we’d like to hear your suggestions as well.

Do you agree that innovation and customer service are slowing down?

Have you found effective steps that you and your peers can take to mitigate the situation?

Let us know by sending your thoughts to tony@ramprate.com or posting a comment on this blog.