For the past few decades, Infrastructure Outsourcing (IO) was a proverbial elephant in the outsourcing room – huge deals, led primarily by multinational corporations (MNCs) and so capital and hardware intensive that some would beat the revenues of some medium-size businesses. At the turn of the 21st century, most non-MNC service providers, especially those based in India, did not even have Infrastructure Management Services (IMS) as a separate business line. Investments required for traditional IO were massive, and none of these providers had the capacity to manage the scale. Only application development & maintenance (ADM) had the scope, size and convenience to suit the global delivery model that the offshore providers championed.
However, as it turned out, IO was too big a piece of cake to cater to the appetite of just the MNCs, and soon offshore providers, cloud players and other boutique IO firms (like IPsoft) arrived on the scene with a commitment to stay in the marketplace. Soon thereafter, with the advent of next-generational concepts such as Remote Infrastructure Management Outsourcing (RIMO), cloud and consumerization, IO achieved some of that nimble-footedness we have come to associate only with ADM.
More buyers, especially the large ones, started to explore the scope-breakdown model that RIMO offered. The huge size and scope of traditional IO required little buyer focus on the nuances of their outsourcing strategy. RIMO provided the buyers with an option to focus decision making not only on opportunity costs but also on strategic choices, i.e., whether and what aspects of infrastructure to outsource. Though traditional IO continued to retain major share of the IO market, RIMO steadily supplanted itself as a viable option (see below).
While RIMO continues to be small as compared to traditional IO, it is a model that traditional IO providers can ignore only at their peril. Astra Zeneca’s recent replacement of IBM with HCL Technologies as its provider of data center hosting and migration is a case in point. Offshore providers may indeed be leveraging RIMO to enter the space dominated by MNCs for so long.
However, this is not a David vs. Goliath story. The IO market is witnessing numerous such evolutions, not only because of what providers are doing (e.g., RIMO and cloud) but also because of what buyers are demanding. The following illustration only partially exhibits the incredibly interesting forces currently influencing the IO market. How the balance tilts will be determined by the innovations that providers bring to the table to align with the growing strategic focus that buyers now have on IO.
Want to know how this story pans out? We’ve covered it in our latest research report on RIMO: Expanding the Wings of RIMO.
We would also love to hear your comments on what you think of RIMO and the related trends.
Achieving the benefits of infrastructure outsourcing used to require the client transfer IT asset ownership to its service provider. The transfer provided not only a one-time cash infusion to the buyer, but also an increase in return on assets (ROA) due to the reduction of its asset base. By negotiating the costs of assets into the contract, the client could also ensure a predictable cost stream over the contract term. The asset transfer also amplified many of the operational benefits of outsourcing transactions, as the service provider possessed the scale and technology management expertise to drive ongoing improvements in operating costs and efficiency.
However, over time, most of these benefits have become achievable without asset ownership transfer. The key contributing factors include the emergence of third-party financing alternatives, remote infrastructure management tools and the introduction of server virtualization technology. A third party lease-back arrangement allows the buyer to eliminate the up-front investment without relinquishing control of the asset base. Most operational efficiencies can now be achieved through remotely led efforts. And the increase in utilization enabled by virtualization eliminates, to some extent, the scale advantage that was traditionally an advantage for a transaction involving transfer of asset ownership to the provider.
Additionally, pending changes in accounting rules will eliminate the advantage of improved ROA that could previously be achieved by either a sale or a sale/leaseback transaction. Current U.S. GAAP does allow ROA benefit if the outsourcing arrangement can be classified as an operating lease. But in August 2010, the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) published a joint exposure draft for public comment that, among other changes, would require that all leases be reflected on the balance sheet of lessees and lessors. In March 2011, the joint boards agreed to several changes to the exposure draft but did not change the requirement to record all leases on the balance sheet. However, I anticipate that in the future all lease arrangements will be required to be reflected on the lessees’ balance sheet, including assets transferred from the client and assets procured by the supplier to provide services that fall within the scope of the lease arrangement. On the other hand, the rules, if changed, will not apply to cases in which the client continues to own the assets, even if the service provider controls and operates them. Ala, ROA benefit from asset ownership transfer is eliminated.
Moreover, recent statistics show an accelerated movement toward adoption of an asset light model in which the client either retains ownership of its assets or engages a third party for a sale/leaseback transaction. Everest Group recently published a research study that found service provider asset ownership in high-value infrastructure outsourcing deals declined from 86 percent in 2007 to 15 percent by 2009. Server virtualization technology and Remote Infrastructure Management Outsourcing (RIMO) versus traditional infrastructure outsourcing will gain even more momentum as the offshore players continue to aggressively expand their market share in this sector.
Additional trends observed by the Everest Group research that support and correspond to this change in business model include a reduction in both term length and annual contract value for infrastructure outsourcing transactions. By 2009, the average term had declined to 4.2 years for traditional tier-one providers and to 3 years for offshore providers. And although at least partially due to the recession, both offshore and traditional service providers saw their deal size reduced by more than half in 2009.
There will always be some segment of the market that continues to prefer traditional data center outsourcing and application hosting models. But I believe that the trend toward next generation models involving RIMO or infrastructure managed services is a long-term phenomena. Although this model results in transactions with lower total contract values, I believe it provides better long-term alignment of client interests and provider incentives. Clients often find it beneficial to retain assets due to the inherent flexibility, control and benefits of scale that it enables. And service providers are able to simultaneously reduce their capital outlays and improve their ROA. Given the trend toward shorter deal terms, this benefit takes on even greater importance.