Although the market is recovering, reported financial performance will continue to be affected until the end of this year, especially for the smaller companies in the sector.
The most crucial element to the success of all services companies is attracting and retaining suitably qualified staff, but as recent profit warnings have shown this can be a double-edged sword.
During the period of up to a year of Y2K-induced inactivity, it was difficult for companies with a higher ratio of salaried staff to contractors to cut their cost base, as they would be faced with making staff redundant only to have to rehire them when customer spending resumed. This meant their options were either to tender at low margins for work to keep the revenue ticking along and staff busy, to involve staff in producing software products that could be marketed separately or to retrain staff to cope with the next generation of skills demands.
Services companies have traditionally experienced a high level of operational gearing, with organic growth constrained by the ability to recruit and train enough suitably qualified staff from a small pool of talented people.
Depending on the disclosure policies of the firms, revenues have been highly visible, being a multiple of utilisation rates, charge out fees and the number of consultants employed. While there are ways to cut costs and increase margins, services companies have found it difficult to break out of the link between staff levels, revenues and profitability.
The good news is it is becoming possible through a variety of ventures including telecoms services, e-commerce transaction-based revenues and application provision services to drive margins up substantially. For example, Logica's core business is building and integrating IT systems but products built on telecoms and billing systems are providing revenue streams which do not depend on staffing levels, including clearing and settlement software, customer care and billing products, a retail banking suite and telecoms portfolio.
Sema's turnover (before the planned merger with LHS Group) is mainly concentrated on systems integration and outsourcing but it has healthy and growing product sales mainly built on telecoms operations. The products division was built using Sema's experience in the sector and research and development expenditure of £44m in the last two years. This heavy R&D cost is unusual for services companies but is necessary if they wish to be serious players in the market.
CMG has developed a product called Wap Service Broker which allows telecoms network operators to implement and control wireless application protocol services. In 1999 CMG's telecom products revenue was more than $120m, up by 102% from 1998 and it is expected to maintain this rapid rate of growth in 2000. CMG invested £13m in 1999 and £7.8m in 1998 in research and development.
Parity is working on a number of initiatives which take a more risk/reward approach to implementing IT solutions. Firstly, in situations where it is working for an e-commerce start-up and it likes the business model, it is charging out its services at a lower rate in return for a share of the company's revenues in later years.
These traditional IT services companies are moving into new revenue streams offering the chance to grow revenues and profits to levels that could previously only have been achieved through buy-outs. However, the distorting effect of Y2K on reported performance will continue to make itself felt for years to come as investors find traditional techniques, such as price/earnings ratios and growth comparisons, provide misleading indicators.
It will be more necessary than ever to carefully examine the potential of the underlying business before making investment decisions in services companies.
Ian Mitchell is an ITanalyst with stockbroker Beeson Gregory. His opinions should not be construed as investment advice.