What I’ve predicted for several years is now happening and the global services industry is experiencing a pricing war. The industry’s core arbitrage marketplace is moving from modest pricing competition to an intense pricing war. Providers’ prices are coming down not by 3 to 5 percent but in some cases by 20 to 30 percent. I’ve blogged about this inevitability for some time, and the last six months showed rapid movement in a downward spiral. Pricing disciplines that providers previously exercised are collapsing. Why has pricing become so precipitous?
Who is driving the intense pricing competition?
Mature enterprise clients, which are on their second or third generation of sourcing, are instigating this market move. They themselves face unrelenting cost pressures and point to providers’ high margins as proof that there are plenty of gains to be had. At the same time as they eye the margins, they are convinced that the next generation of cloud, automation, and as-a-service offers provide breakthrough cost advantages; and they seek to combine all this into step-change gains.
With these raised expectations also comes a willingness to switch providers and a realization that the barriers to switching have been greatly reduced. This is evident in our statistics, and I blogged last year about the increasing anti-incumbent bias.
Factors exacerbating the downward spiral
In addition to enterprises’ effort to drive pricing down, other market forces add to the momentum toward a pricing war. As enterprises’ willingness to switch providers increases, incumbent service providers are increasingly in an untenable situation. Investors reward firms that demonstrate growth; so providers can’t afford to have lower-priced competitors capture large chunks of their existing revenue. In addition, the maturing arbitrage market no longer gains share from traditional models at the same rate.
As the prospect of losing existing customers becomes increasingly painful, a retain-at-all-cost dynamic is increasingly the tone forcing account teams to drop price for existing customers while encouraging providers to use lower prices as the way to win new customers.
All these actions create a downward spiral that feeds the enterprise customers’ belief that pricing must come down. And voila! We have gathering momentum on a pricing war.
I think the implications for the industry are very significant. The days of relying on contractual switching costs to protect providers are over. Switching costs have eroded and providers are left with no choice.
I think the new normal will be much more competitive pricing – certainly for mature clients, but also it will spread to new clients. Clearly the idea of getting COLA adjustments is an uphill climb.
I’m not saying there is a race to the bottom in all market segments. Certainly providers in the growth areas such as as-a-service models and digital technologies and value-added areas will be able to command high margins. The challenge for the industry is that the core of business is in the quickly commoditizing spaces with a customer base that is unwilling to pay a premium. We must accept that this is happening.
It brings to my mind words in a Dylan Thomas poem: “Rage, rage against the dying of the light.”
I blogged last year about the growing anti-incumbent bias in the services industry. That’s not to say that clients are biased against incumbent providers, but there are more clients who want to switch out providers than there used to be. This is true across every segment of global services (applications, infrastructure and BPO). We can trace at least some of this client mindset back to providers’ actions that are similar to the farmer in Aesop’s Fable who killed his goose that laid golden eggs. In their haste to get more golden eggs (more profitability), providers unintentionally kill the golden substance inside their goose (existing client base).
At the heart of the issue is providers’ wrong view of their clients. As a result, they take actions that cause clients to believe the provider exploits them, as the actions benefit the provider’s revenue. When a client believes the provider is only interested in maximizing its revenue, the client no longer sees the provider as a trusted advisor.
Here are three examples I’ve observed in which providers appear to act for their own interests, which results in clients no longer trusting them.
The provider moves from an FTE-based model to a transaction-based model, but the provider’s revenue stays the same. Basically the provider finds a way to charge the client more for volume, which wouldn’t need to happen under the FTE-based model. Clients see through that, and the provider loses its trusted position. Clients realize the provider is exploiting them rather than serving them.
The provider moves to a productivity model, promising to support portfolio apps at lower cost through a managed service. What actually transpires? The provider nickel-and-dimes the client, which ends up paying more money over time. Functions that were delivered in the FTE model are now a la carte, outside of the new model; so the client actually pays twice for the service.
The provider flattens out its factory model and optimizes it to use junior resources instead of senior resources. The net result for the client is churn in the provider’s resources, so the provider doesn’t build client or industry knowledge. On top of the churn, the client actually ends up with lower productivity because junior people now do what senior people were doing.
And that’s how providers kill the goose that laid golden eggs.
With the rise of smart machines and robotic technologies replacing labor arbitrage, multi-sourcing becoming a norm, and “as-a-service” models increasing in adoption, the IT services (ITS) market is undergoing radical change. And it could wreak havoc on – or mean opportunities for – ITS providers nearing deal renewal time.
It’s abundantly clear to us that multiple hunters over the last few months have been eyeing big portions of the US$76.3 dollars in IT services contracts soon to be up for renewal. And if they’re not careful, it could mark the end of millions or billions worth of business for several companies. The verticals primarily at stake are BFSI, Healthcare, and Energy and Utilities, which have a combined share of more than 55 percent of the total pie.
But before we talk about how these providers can fend off their attackers, let’s take a quick look at the state of the market, per our recently released Report on Upcoming Contract Renewals (ITS) – 2015:
BFSI continues to remain the dominant vertical in the total value of deals expiring in ITS; 94 percent of the deals in this sector are with large service providers (with revenue of greater than US$5 billion)
Western Europe is the dominant market for expiring high value IT deals, accounting for 55 percent of the total number of expiring billion dollar deals
Infrastructure services are included in the scope of more than 77 percent of the total value of ITS deals, and 55 percent of these deals are due to expire over the next year. Data center and network services are the primary components in more than 70 percent of the total expiring ITS contracts
Pure application services (AS) comprise 25 percent of the total value of the entire ITS pie. Large service providers of BFSI and Travel and Transport support services will drive 60 percent of the total AS renewal spend over the next two years, concentrated primarily in North America and Western Europe. In fact, the highest valued IT deal expiring in the next two years is a pure AS deal with a French Travel and Transport provider
With so much renewal money up for grabs, who will win the hunting game? A David versus Goliath story is currently playing out in the deal renewal industry. Incumbent service providers want to expand their footprints across clients and fend off the attacking competitors. Attackers are desperate to penetrate newer opportunities by eating away share from the incumbents.
The reality is, the incumbents have a lot more to lose than the attackers. Given high anti-incumbency sentiment in the deal renewal market (~40 percent of deals are not renewed with incumbents), these providers need to take a serious look at their traditional deal renewal strategy, taking into consideration:
Enterprises are no longer willing to sign up large IT services deals spanning multiple years due to factors such as vendor lock-in and lack of transparency; as a result, best-of-breed solutions may emerge as the better option
These massive service contracts have tapered off over the last decade, since customers are now more willing to disaggregate the requirements into different IT towers or services
Enterprises realize that these large deals may not be able to flex to changing business requirements.
At the same time, attackers can’t reduce their efforts and investment in winning new clients. Despite all the challenges with incumbents, enterprises typically default to them fearing cost of change management and disruption. The onus lies on the attackers to demonstrate value beyond niche positioning or price aggression. Attackers need to invest early in building credibility with the enterprises. They need to communicate value in tangible terms beyond cost savings. And they need to make themselves visible to gain mindshare of their target clients. It’s a cultural overhaul where attackers must promote both their vision and their delivery capabilities in the market.
It is difficult to predict what lies ahead in this hunting game. But there will certainly be winners and losers. If you’re an IT service provider, will you be one of the winners?
Every morning in Africa a gazelle wakes up knowing that it must outrun the fastest lion. Every lion wakes up knowing it must outrun the slowest gazelle. So when the sun comes up in Africa, you’d better be running. We see this happening in the services world — as cloud and as-a-service models move into mainstream adoption and trump labor arbitrage, everybody is running and the hunters become the hunted.
It’s clear that the services world is changing due to the new technologies and models. Historically the dominant players in one era failed to make the transition and become dominant players in the next era. Established dominant hunters do not know how to behave or succeed as game; the emergence of a super predator disrupts the natural order.
The dominant providers really struggle with making the change. They talk about it. Their senior executives recognize the need. They have structured their business to perfection to facilitate the incumbent model. It’s very difficult and very unusual for them to successfully transition to a new model. We see this time and time again.
Here’s a real-world example. I was on an airplane and headed home after a meeting with senior executives of a major IT provider. At the meeting they laid out their commitment and strategy to cloud and as-a-service models and the massive investments they made and are facilitating to make to facilitate this transition.
On the airplane I sat next to another executive from the same company. He was returning from a trip to South America where he advised clients about future technology. He spent most of the trip spouting scorn and ridiculing that the new cloud technologies are not appropriate to run enterprise-class applications and stating confidently that they would never replace or threaten the existing order.
Think of the confusion and conflict customers face when they hear dueling and contradictory positions coming from the same company. They are much more likely to adopt a provider that is completely aligned with the new models. This is why, historically, challengers succeed.
A similar situation occurred when I returned from a provider conference where top execs laid out their grand vision. But less than a week later Everest Group observed the provider working in a client account and the account team espoused exactly the opposite of what the senior leaders said.
We see similar behavior within Indian firms. They make the most money when they deliver work from a low-cost location (ideally a tier-3 city) with the most junior people (the freshers). That’s the heart of the pyramid, the heart of their factory model and it achieves the highest margin a service provider can make. Incumbent providers with factory models have high turnover as they constantly push to the next generation of junior people coming in.
They do this even though they know their customers want less turnover and more work delivered onsite at the client or at least in country as they want more customer intimacy. So their needs and commercial interests are unaligned.
We see providers’ executives making big announcements about more people delivering services in country and on site. But what their salespeople say and what the management and operations people do is the opposite.
In the above examples, providers’ employees did not buy in to the new models. And this is but one of a thousand different points of alignment that needed to happen. The incentive structure, organization structure and underlying technology enablement must change. And the hearts and minds of employees need to change.
Customers aren’t stupid. And they do change providers. We’ve seen a big jump in challenger models across the board in outsourcing. Increasingly the challenger has an advantage over the incumbent. They’d better be running.
As we work with service providers across the industry, a theme we hear increasingly is the buyers’ unrelenting pressure on providers to reduce price. The pressure is exacerbated by the growth slowdown in the industry. I believe this pricing pressure will soon show up in providers’ financial performance with decreased earnings per share.
The unrelenting pressure — which also seems to be growing — is linked to the power of purchasing departments and their inability and unwillingness to consider factors outside of price per unit in decisions.
The pressure frustrates service providers across two dimensions. First of all, it’s always unpleasant to have a services client ask a provider to reduce its price when its costs are rising. I think this is one of the reasons why we see a rise in anti-incumbency that I’ve blogged about before. If not the number-one reason, it’s at least a significant concern of service providers. Customers increasingly ask their providers to make investments in the customer’s business, but their pricing pressure deprives the providers of the margins with which to do that.
The second frustrating aspect is that the pricing pressure creates a set of unintended consequences. Most notably, there is less and less time for clients to take into consideration quality, total cost or total efficiencies the providers deliver. Instead they place more focus on reducing the cost per FTE or cost per unit.
It was easier for providers to resist, or at least manage, pricing pressures when the industry enjoyed a fast-growing marketplace thus affording providers the benefit of scale. In addition, most service providers also have been fortunate over the last few years to have forex tailwinds with the dollar to rupee or the pound or Euro to rupee. But the rupee depreciation can’t go on forever and may well be reversed as India puts its house in order.
Certainly there are growth areas in the market today: automation, cloud and as a service. And providers have the possibility of changing pricing algorithms from FTE-based deals to transactional outcome-based deals. However, those techniques are uncertain, difficult and, taken collectively, may not be sufficient to offset the downward pricing pressure on a provider’s core business.
The cowboy song by Rhett Akins, “That Ain’t My Truck,” where he discovers his girl has left him for another guy, reminds me of the anti-incumbency bias occurring in today’s global services marketplace. What’s causing clients’ infidelity to their incumbent providers?
I believe many incumbent service providers find themselves displaced today because of three factors.
Services that clients once viewed as value are now just a commodity. Almost all services commoditize over time. And at that point a service that was once a differentiation of the provider no longer is different from other providers’ offerings.
Client and provider interests become unaligned. When interests aren’t aligned, the client comes to believe the provider delivers services in a manner that benefits itself rather than working for the client’s benefit.
The service provider takes the relationship for granted and the customer sees it increasingly as day-to-day business. Figuratively speaking, the provider forgets to bring roses. I’ve blogged before about this relationship phenomenon where clients tell Everest Group they get no innovation (continual added value) from their providers.
Incumbent providers should keep in mind that Taco Bell is not fine dining and a trip to Galveston is not the same as a trip the south of France. Just as with relationships between men and women, commercial relationships also need forward momentum. Without making an effort to build a deeper relationship, it will go stale or even go backward. Management changes and employee turnover in the provider organization aggravate this situation.
Clients now have a variety of options when it comes to service providers. Incumbent providers that don’t want to find their clients with another provider’s “truck” are wise to focus on the above three factors.
Nearly US$5 billion in payer ITO contracts are due for renewal from 2015 through 2020, and rising anti-incumbency, coupled with intensifying competitive landscapes, have heightened the risk profile for incumbent service providers
While robotic process automation (RPA) is creating opportunities for the newer breed of service providers, their more established competitors are feeling the pressure of change. RPA would cannibalize the established service providers’ labor arbitrage business which they have invested in for decades. At an initial estimate, we see a phenomenon of 40-40 emerging which means 40% of existing BPS work is likely to get impacted by RPA with a 40% lower cost impact. Free of this legacy, newer service providers can ride the wave of automation to gain market share quickly. Cannibalization is not the only threat to established vendors. The RPA disruption has coincided and in part fuelled the current trend for anti-incumbency. In 2013, for example, Everest Group research shows that over half of Finance and Accounting Outsourcing (FAO) contracts were taken away from the incumbent provider when they came up for renewal. In this market the newer breed of service providers could be seen as agile and unencumbered by legacy investments in labor arbitrage. However, established providers are also upping their game and this means it will likely be a buyers’ market in the mature BPS segments.
The Newer Breed of Service Providers
The newer breed of service providers are those which have either focused strategically on RPA as a growth engine (and have limited legacy non-voice BPS business), or which have been newly established as pure-play RPA-based service providers. Let’s look at the one illustrative provider in each of these two categories respectively – Sutherland Global Services and Genfour.
Sutherland Global Services
Sutherland Global Services (SGS), a leading contact center player, is arguably one of the first service providers to strategically focus on RPA as well as actively market it for the non-voice BPS space. It has made automation a key part of its proposition and is leveraging it to differentiate itself from other service providers that either rely heavily on offshore resources or global majors that can implement automation through major transformation and system integration projects. This strategic focus has led it to develop partnerships with RPA technology providers such as Blue Prism. It has also seen the company develop its own RPA software layer which links to and supports third party automation technologies. Another key capability that SGS has developed is a 24×7 control tower, which maintains existing automations to ensure continuous operations.
SGS refers to a recent contract win as a sign that its focus on RPA is paying off. As part of the RPA-led BPO deal with an European travel company, it is taking over two operational centers in Scandinavia and Estonia. It already has circa 400 people in Sophia delivering transactional and front-office services. The largely U.S. based service provider will leverage the additional delivery centers to grow in Europe. That growth, according to SGS, is going strongly with annual targets reached and exceeded part way through its financial year. Other RPA-led deals are in the pipeline.
We believe, as a relatively newer service provider in the non-voice BPS space, SGS is transitioning to a mostly automation-enabled provider in the back- and middle- office. We estimate that automation currently accounts for 10%-15% of its FAO & middle-office services but is rising fast.
Genfour was founded in 2012 to offer a different way of providing back-office services. Today it offers Robotics as a Service, on a cloud-based infrastructure on-demand. The proposition to lower costs is strong given the benefits of automation combined with a cloud infrastructure. Its challenge is to win over skeptics that do not yet believe that robots can do as good a job as people in delivering business processes.
Genfour also offers consultancy, development and on-going run operations. It has gained six clients since it was established and these include organizations such as NHS Scotland, IFDS, Coral and RAC.
Genfour is building an annuity-based business model where, not only does it generate revenue from the reselling of robotic software but also from managing every robot that it operates on behalf of its clients. It is already achieving a high operating margin for a business process service provider at 22% in H1 2014. This is set to stay at 20% to 21% full year.
Both SGS and Genfour see the use of automation as a good fit to the increasing buy-side appetite for transaction or outcome-based pricing instead of the input/FTE-based model. Genfour started out with its “as a service” model while SGS is in a transition state. It is offering banded pricing using virtual FTEs and some blended pricing where people and robots are mixed.
Anti-incumbency provides opportunities for the newer breed of service providers which could be seen by potential clients as agile an unencumbered by legacy investments. However, these service providers will have to have the ability to scale services and offer slick switching processes if they target contract renewals. Competition is intense in the market with established service providers making investments to optimize and streamline the switching process. For example, multiple service providers have developed specialized transition management solutions to streamline switching and subsequent transition.
Established Service Providers
There has been a great deal of buzz about RPA in the market recently. This is making established service providers increasingly highlight their own automation capabilities and make new strategic alliances with third party automation software vendors. Examples include EXL, Infosys and Steria which have been largely using their own automation tools. In addition, some such as Steria and Genpact, have also set up partnerships with third party software vendors (e.g. Blue Prism & Automic). These and others will be looking to narrow the gap in mindshare between themselves and the new generation of service providers which have gained market share through strong messaging and strategic use of RPA.
Buyers are increasingly becoming focused on higher-end value proposition. They are willing to switch to a new provider, in case the incumbent is unable to deliver value beyond just labor arbitrage and basic process efficiency. Established service providers that are building on their RPA capabilities will be looking to make up for cannibalization of revenue by opening up new higher value opportunities such as analytics services. RPA can help them reduce internal costs too. Apart from helping the bottom line, given anti-incumbency, this would enable them to more easily absorb the cost involved in clients switching.
Everest Group will be publishing a report on Service Delivery Automation (SDA) shortly. It will be discussing the findings of the report at its half-day Robotic Process Automation event for buy-side clients in Dallas on October 22nd. Review the agenda and request an invitation.
Watch out for forthcoming research reports from Everest Group on anti-incumbency, analytics, and technology / automation in the BPS space for a deeper-dive into these dynamics.