Profit: How Established Solution Providers Are Racking Them Up

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 and 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."

While some CEOs are sticklers for indirect costs, others are laser-like about direct costs, which in the case of a services firm usually translates to head count. While bodacious utilization rates are foremost on every executive's mind, it could be argued that Joel Ronning, CEO of Digital River, carries it one step further: He is loath to hire one extra person from the get-go. Refusing to spend in front of revenue, he prefers to fill in on the back end.

Ronning says to contain costs, and thus increase profits, he orders a weekly forecast that serves up actuals against budget. He's also a fanatic for metrics. "Call-to-order ratios, the average value of an order, abandon rates--you name it," he says. "If Digital River can find a metric, it'll attach it." Maybe that's why, with growing e-commerce sales and an ever-expanding international footprint, the Minneapolis-based company with 700 workers had the confidence in its profitability game plan to raise guidance on both sales, from $142 million to $145 million, and dilute pro forma earnings per share to 90 cents per share, up from 87 cents.

Ronning's cautious pessimism is affirmed by company results. Net earnings per share was 21 cents, more than double what it was for the same quarter last year. And operating income was $6.9 million, up from $2.5 million a year ago.

Some major players enjoyed massive turnarounds year-to-year, including Covansys (VB 100), with year-over-year quarterly growth of 28,487.5 percent; Intergraph (VB 77), which enjoyed a 1,800 percent jump; Geac (VB 92), with a year-over-year quarterly growth of 1,096.7 percent; and Zones (VB 91), with a 10,280.8 percent increase over its second quarter in 2003. Most numbers are attributable to major one-time events, like sales or purchases.

Both Ronning and Keane, as well as other CEOs VARBusiness interviewed, believe utilization rates (the percentage of billable hours per professional) are instrumental to profitable returns, a sentiment echoed by Ken Wasmer, the head of his own consulting firm, Wasmer Business Solutions, which targets the tech industry.

Wasmer likes to focus not only on utilization rates, which he says should preferably be 75 percent or higher, but on what he calls the realization rate--the percentage of dollars actually collected of the total billed. Realization rates should be greater than 90 percent, he advises.

Wasmer says VARs need to adhere to such rules to reach and maintain profitability. He also advises his VAR clients to price according to talent, like law firms and accountancy do, then offer clients what they want, suggesting that they hire top shelf only for difficult engagements or the most specialized elements of engagements. He also recommends that solution providers avoid pricing on a cost-plus basis.

Like Ronning, Mac Slingerlend, president and CEO of Greenwood Village, Colo.-based Ciber (VB 71), takes little for granted in his never-ending quest to ensure profitability. "If it isn't tough today, it'll be tough tomorrow," is his rule of thumb.

The Ciber boss, like Keane, was enthusiastic about his whittled-down SGA expenses, at 20.5 percent for the quarter. "It was the lowest we've ever had," he says with pride. "And the biggest part of our performance." Slingerlend attributes the showing to relentless cost-cutting every minute of every day, as he put it. He's slashing his bench, taking a hard look at leases. When they're up, he cuts a deal for less or takes less space.

"I find myself in conversations all the time, trying to postpone expenses to the next quarter," he explains. As Ciber piles up the revenue--it reported record sales of $208.3 million for the quarter, up 18 percent from the June 2003 quarter and its best since June 1999--it was able to refrain from adding to the cost side--a must--Slingerlend says.

"We're up 50 billable people, but only two overhead people. That means more revenues with less overhead," he says. For the three months, the pure-play international systems-integration consultancy had net income of $7.9 million, or 13 cents per share, compared with $6.8 million the previous year. Operating income was $13.9 million, against $11.3 million a year ago.

Slingerlend points out that for Ciber--indeed for all solution providers--the second quarter is usually a strong one. It encompasses fewer holidays than other quarters, translating to more billable days, he explains, and there appears to be fewer vacations taken by employees. "With our industry, you make hay in the first half, and then you stay steady in the second half," he says. "There are too many nonbillable hours in the second half to outperform the first half."

It also pays to revisit your compensation plan. That's what John Sheaffer, president and CEO of privately held Sysix (VB 388) did, and it drove his profitability up 20 percent for the second quarter over last year--on track to triple net income to more than $1 million for the year.

He attributes the boost to upping commissions to sales reps for selling services over products. Sheaffer also decided to incent his presales staff individually instead of in a bucket, a move that got them to take a good look at remarketed equipment as an alternative for its customers. Sheaffer also says that increasing familiarity with IBM vendors programs (Sysix has lessened its dependence on HP, which once represented 80 percent of its sales) has helped. In fact, a number of solution-provider CEOs say that navigating one's way intelligently through vendor programs can increase profits. Look carefully for vendors that offer exemplary deal-registration rebates and other back-end programs, then work them aggressively to build margins, advises Bob Venero, president and CEO of Future Tech Enterprises (VB 355). And don't get bogged down with paperwork to get those rebates--that will eat into profits more quickly than you might realize.

"One of the drags for us is how much we spend in rear-guard action with vendors," admits Lewis Johnson, CEO of privately held Siwel Consulting (VB 228). "It's very risky to bet your business on back-end programs. IBM is pretty good, but all vendors have anomalies."

And don't forget to be--there's no nice way to say this--cutthroat. That means taking advantage of competitor softness, firing non-producers, whatever it takes. Sysix's Sheaffer says he keeps the costs of expected sales as low as possible, at least in part by getting rid of tired blood. "You turn out people who are mediocre and find someone who's more talented," he says simply. "In the last two years, I've actually lowered our average personnel costs by 10 percent." An unpleasant truth to voice out loud, without a doubt--but no one said profitability is pretty.