Profit: How Established Solution Providers Are Racking Them Up

Is it possible that the second quarter of 2004 will go down in channel history as a demarcation point, marking the start of--dare we say it--steady profits? Have the bloodletting, 110 percent utilization rates and 360-degree partnering initiatives finally yielded results? Despite some soft August vendor earnings, it appears so.

Because for every integrator that had a rough quarter, like Convergys (No. 38 on the VARBusiness 500), whose net income earnings fell 32.9 percent when comparing second quarter 2004 to last year's numbers, there were twice as many stellar performances from VARBusiness 500 topliners such as Boston-based Keane (VB 63), with a second-quarter net increase of 22 percent over the previous year, and Digital River (VB 211), which won this year's VARBusiness 500 Top Profit award and beat guidance while almost doubling earnings per share.

In fact, a check of the new VARBusiness Profitability Scorecard (see page 34) indicates more than two-thirds, or 94 of the 134 individual publicly held solution providers, showed a percent increase in net income during the second quarter of 2004 from the same quarter last year. That's a pretty good uptick for an industry that has been badly battered in recent quarters. And it's a strong sign that this year is going better than last.

Among those 94 solution providers with positive net-income percentages, 38 net-income gains were in the triple digits, and 88 were net-income gains of 10 percent or more.

Two companies broke even from April to June for their second consecutive year. The remaining 38 companies, or less than 30 percent, made less money during the second quarter than during the same time last year. Some of those were major VARBusiness 500 companies, including The Titan Corp. (VB 42), which posted a bone-chilling year-over-year second-quarter income drop of -1,234.7 percent, and CompuCom systems (VB 46), which reduced its quarterly income by -780.8 percent from year-over-year quarters.

In most cases, dramatic gains--and losses--are attributable to specific one-time events, such as a purchase or sale (go to www.varbusiness.com for the explanations behind the big winners and losers). If you're looking for a benchmark, John T. Mahoney Jr., Raymond James & Associates' senior vice president of equity research, says that he estimates an average increase in profits of 15 percent for the quarter ended June 30 over Q2 '03.

"Excluding charges and one-time items, we would say the percentage increase in net income for the June quarter among IT services firms could best be described by a matrix, with one axis being size and the other breadth of services," Mahoney explains. "Many small, niche service providers generated net income growth of well over 100 percent, as many of these companies had been operating near or below break-even levels.

"Moderate sequential revenue growth translated into big increases in profitability," Mahoney continues. "Large service companies with diverse offerings experienced income growth in the mid- to high teens. This was driven by high, single-digit organic growth, acquisitions and moderate profit improvements. These organizations are increasingly focused on large outsourcing arrangements, which smooth out results."

Quarterly Glance
An analysis of second-quarter-over-first-quarter numbers shows that more than two-thirds, or 91, of the 134 solution providers made more money during the second quarter of 2004 than they did during the previous one. Of that group, 28 were in the triple digits, registering net income gains of 100 percent or more over the first quarter. And 78 posted net income gains of 10 percent or more. The remaining 43 companies, or less than one-third, made less money than the quarter before.

The overall results indicate the second quarter was tougher for more solution providers than the first because the total number of companies that lost money between quarters is greater than the number that lost money on a year-to-year basis.

The big five integrators--IBM Global Services, EDS, Accenture, Computer Sciences Corp. and Hewlett-Packard Services--all made money, their gains roughly consistent with the rest of the pack. EDS, coming off a rough-and-tumble 2003, leads the bellwethers with a 206.8 percent quarterly gain over the same period last year, although it still lost $84 million in operating income. The rest all had year-over-year double-digit income gains, save for HP Services, which came in just under at 9.3 percent. Revenue increased across the board year to year for all companies, although IGS and CSC were down quarter-to-quarter, albeit in the single digits.

So, while it's a possibility that the seemingly temporary vendor dryout might smack down second-half integrator earnings, it's more likely solution providers have learned harsh lessons in the past few periods and are determined not to let it happen again. Looking ahead to the third quarter, Mahoney thinks margins will expand "as long as the economy continues to improve." The analyst says the biggest profitability gains will come from smaller services firms.

VARBusiness asked many top solution providers how they did it in the second quarter. During discussions with these providers, it became clear that while there are a host of variables that CEOs need to monitor their operations 24/7, the executive running the show typically relies on a favorite button to push to maximize his or her machine's throughput.

Take Brian Keane, CEO of the $805 million IT-outsourcing firm Keane. He's intent on, and very proud of, the company's ability to hold its selling, general and administrative (SGA) costs in check, and he believes they have been the critical link to Keane's profits. For its second quarter, Keane's SGA costs in percentage measurements dropped 200 basis points, from 24.7 percent in its first quarter--near its typical mid-20s range--to 22.7 percent this past quarter. At the same time, Keane reported sequential revenue growth of 7.4 percent over the first quarter.

The key, Keane thinks, is keeping indirect costs, which he defines as SGA costs, in line by monitoring expenses and consolidating functions as the company grows. "We built an operating model that can support considerably greater revenue without adding indirect costs," he says. When a solution provider expands, for example, it doesn't need another managing director or more HR. Don't expand SGA rates at the same rate you expand verticals and/or geographies, he warns. Keane boosted net income for its second quarter by 21.9 percent to $8 million, up from $6.6 million a year ago. Operating income was $13.3 million, compared with $11.5 million posted a year ago.

"Eventually," he says, "we will get to the point [after we grow and/or acquire enough] where we will need to increase SGA. But I would argue that for all services firms, [one of the] key drivers of profitability is critical mass. The larger you are, the more you can spread around costs."