IBM Earnings and the Axe on Cost of Services

On Jan 20th, IBM released its Q4 earnings report. For the current economic environment, the news was very encouraging:

  • Total revenues only slightly down by 6%
  • Services revenues only down by 4%
  • Net income up by 12%

Right now, we are crunching the numbers for our Service 50 webcast next week. Similar trends are emerging in the data. Through the end of last year, technology providers continued to weather the storm regarding top line revenue and bottom line profitability. Revenues were off a little but bottom line profits remained strong. However, IBM is the canary in the coal mine regarding what is about to happen to embedded technology service organizations of all sizes.

In October of last year, at the Technology Service Conference in Vegas, we presented analysis on the following positive trends in the business models of technology solution providers in the Service 50 from 2004 to 2007:

  • Top line revenues have been increasing
  • Operating incomes have been increasing
  • Service margins have been holding steady (not decreasing or increasing dramatically)
  • G&A expenses as a % of total revenues have been declining
  • R&D spending as a % of total revenues has remained flat

In summary, tech companies have been improving their bottom lines by holding R&D costs flat and optimizing G&A. So far, so good. Now for the concerning observations:

  • Sales and marketing costs as a % of total revenues are trending slightly higher
  • Cost of services (COS) as a % of total revenues are trending much higher

In other words, more of every dollar a tech company makes is being spent to secure customers and continue to service them. One of the reasons the COS number is spiking higher is because the percentage of total revenue coming from services has drifted higher for many of these product companies. Now, let’s look at a frightening scenario we shared in October that could unfold in companies that do not optimize both sales and services costs:

COS Trends

COS Trends

What this graph shows is that services will become one of the most significant centers of cost for companies that basically consider themselves product companies. If companies don’t control these services costs, operating income will clearly suffer. Now, we are not making wild predictions on market performance here. We are conducting a type of analysis Bill Tancer, the author of Click, refers to as “data arbritrage.” We are simply harvesting existing data about a market that allows us to see what is already happening before everyone else notices. If revenues remain flat in 2009 and these tech companies want to maintain or increase their operating incomes (like IBM did), then they will have to look aggressively at their cost of services. It is one of the few significant sources of cost that has not yet been optimized. The data points to this brutal fact.

My greatest fear in this unfolding scenario is that tech companies will cut services costs by wielding a very blunt axe. The greatest source of cost in services is human capital. Tens of thousands of services employees could be let go by tech product companies in 2009—all in the pursuit of protecting the bottom line. Starting with IBM. Unfortunately, tech companies will not know if they are cutting service capabilities that are critical to financial health when economies rebound. Services organizations are poorly equipped to convincingly diagram how lost services capabilities translates to a skinnier bottom lines through lost revenues and lower renewal rates. The result could be the gutting of services infrastructure and workforces. And the ability to rebuild services capabilities is much harder than the process of cranking product volume back up.

For services leaders, now is the time to ask your executives two key questions:

  1. What capabilities will help our company survive this downturn by maximizing wallet share with existing customers?
  2. What capabilities position us to quickly capture market share when the economy rebounds?

The real answer to those two questions is most likely “services”. The perception may be costly to the health of your services organization.


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