After getting divorced from accounting firms because of the Enron Corp./Arthur Andersen scandal, many consulting companies are trying to redesign their future. Technology firms, it turns out, have been among their most ardent suitors. Although IBM’s purchase of PwC Consulting, a division of the consulting firm PricewaterhouseCoopers, was the first such match-up in this sector, experts suggest that many more marriages will follow.
The best positioned player appears to be Hewlett-Packard, which already made a leap into the world of consulting three years ago when it launched an offer of 18 billion euros for PwC Consulting. That deal appeared practically closed but, at the last moment, it suffered a setback. In November 2000, HP CEO Carly Fiorina put an end to the deal after the technology company collapsed on the stock market because it couldn’t achieve its earnings projections for the fourth quarter. Weeks earlier, the president and managing director of HP had warned that it would not buy the consulting division of PwC unless it lowered the price of the purchase.
The price cut came through but it was IBM that ended up benefiting from it. On July 31, 2002, IBM acquired the consulting firm for $3.5 billion, an amount only about one-fifth as much as HP’s offer. The news alarmed the sector. On the one hand, manufacturers saw how the leader of the marketplace had stolen a march on them. On the other hand, the consulting firms had placed bets on which company was going to be the next to receive a juicy offer for losing its independence. To top things off, from then on, the consulting sector was about to enter one of its most difficult periods.
Andersen’s involvement in the Enron scandal – the U.S. energy company’s suspension of payments marked the starting signal for a long series of business scandals – culminated with the disappearance of Andersen, which had been Enron’s auditor but also had billed it for consulting services. This dual role awakened the old conflict of interest issue, leading to renewed questions about whether the auditor in charge of reviewing a company’s accounts could be impartial if it was also doing consulting, in effect becoming the company’s business partner.
The debate caused lawmakers around the world to consider the necessity of separating consulting companies from accounting firms. The United States took the initiative with the controversial Sarbanes-Oxley law, which establishes nine types of incompatibilities. “This law is very interesting because it marks a new start in this sector, and obliges companies to redesign their strategies,” says Rafael Garralda, professor at the Instituto de Empresa. “The great appeal of the Big Five – the five biggest accounting firms – was in the implementation of systems. Laws as well as the marketplace are forcing them to split up.”
To make things worse, the change in the rules of the game has come at an especially delicate time for consultants. The economic recession has forced companies to tighten their belts and reduce their consulting contracts. Eric Weber, a professor in the department of accounting and control at IESE, and director of the MBA and Global MBA [programs], is certain that this environment favors small firms. “They are more competitive in price. Moreover, because there are no large contracts now, every company has to fight for the small contracts and lower their prices in order to sign agreements.”
During the past year, prices for consulting have fallen around 20%, according to data from the companies. “In lean years, the big consulting firms know that they are the only ones capable of taking care of the big projects and, as a result, they can raise their [terms],” explains Weber. “But when the market weakens and there are only small contracts, they have to lower their expectations and compete at lower levels.”
A Question of Margins
Weber believes that “In order to really understand what this period means for consultancies, you have to bear in mind three different factors. On the one hand, there is the economic situation, as a result of which companies are making big cuts in their consulting service contracts. On the other hand, there are pressures on the consultancies’ auditing divisions – which means, companies have to buy these services from two different firms in order to avoid being caught. And, finally, there is the interest of the technology companies” [in buying consulting firms.]
On several occasions, IBM, HP, Fujitsu, EDS and Dell have all admitted that they are interested in getting into the service business. Some companies, such as IBM, Fujitsu and EDS, have intensified their interest in acquiring a consulting firm. Meanwhile Michael Dell, Dell’s founder and chief executive, is touting his company’s business services, which employs 8,000 people and generates $3.5 billion in income. Almost half of this figure comes from professional services, in comparison with 17% two years ago.
“The problem of the manufacturers is that they have been increasing their supply of consulting services and now it turns out that they don’t know how to integrate all the solutions they have implemented,” says Weber. “This requires an authentic consulting arm that allows them to fit together all the various stopgap measures that they have been putting in place for their customers.” That is the goal that IBM pursued when it acquired PwC Consulting. With that transaction, Big Blue consolidated its leadership position in the service sector, where it bills more than $36 billion. Moreover, this business sector already represents more than 40% of the company’s revenues.
According to research firm IDC, many companies are looking into similar alliances and are daring to risk possible corporate marriages. HP appears to be the most advanced company in this regard. After HP’s failed attempt to buy PwC Consulting, IDC is sure that a good option would have been the acquisition of Deloitte Consulting. Such a merger would have created the second largest European company in this sector with annual sales of $5.79 billion. Nevertheless, that deal is becoming more complicated every day as a result of the decision that Deloitte made, last March 31, to reject splitting off its consulting business.
“When the economy recovers, there are going to be more buy-outs,” Weber predicts. “It is extremely clear that the interest of technology manufacturers in consulting firms reflects the question of margins. Computers have become a commodity today. Although you plug yourself into a network of technology, it is the services that really generate wealth. Therefore, big companies are moving toward this business model.” The steady decline in margins for hardware and software is also leading manufacturers to search for new income models. Moreover, the rising number of competitors is forcing manufacturers to look for differentiation not only in the products but in the services as well.
This strategic interest has also been transferred to the marketplace, where any rumor about a possible alliance causes the share value to bounce. One example is what happened last November 22 at EDS. Its shares closed up 7.8% as a result of rumors that EDS would be purchased by IBM. EDS is one of the few technology companies that already have a consulting arm. Having acquired AT Kearney three years ago, EDS is a leading firm in strategic consulting. Nevertheless, the technology bubble and the economic recession forced it to make important adjustments in its personnel. During the past fiscal year, its earnings fell by 18.1%, to 1.16 billion euros.
Like EDS, Fujitsu, is also active in the consulting world as a result of [its acquisition of] DMR Consulting. Many other deals are in the making as well. BearingPoint, created by the merger of KPMG Consulting with the consulting division of Andersen, is one of the names that never stops being heard on the stock market floor. It is ready and willing to continue being a general consulting firm that is very focused on business. Its size – billing $3 billion – makes it small in comparison with IBM, Accenture or Cap Gemini-Ernst & Young.
For its part, the last name on that list has just put an end to two years of restructuring following its purchase by the consulting division of Ernst & Young. With this deal, the company, which bills 8.4 billion dollars and deals with a technology market profile, wanted to win a strategic business arm that would provide it with a broader consulting focus. But its dreams of greatness may be swept aside with the arrival of the large manufacturers in this sector. Dell, considered one of the most stable companies in the computing world, may be one of those manufacturers. IDC is certain that it could close a successful deal if it bought Getronics, a European consulting firm that has plunged into a deep economic crisis.
Garralda summarizes the strategy that companies are following with this simple phrase: “These days, no one wants to say that they implement information services – they only implement solutions.” This approach, which relies on outsourcing as its instrument for achieving profitability, responds perfectly to the new challenges of the market, says Weber. “Considering the speed with which technology is changing, it makes less and less sense to make major investments in equipment, and then hope to amortize it in 10 years. By contrast, outsourcing has the great advantage of converting fixed costs into variable costs.” In this way, companies are not exposed to the impact that changes in technology can have on their accounting results.
According to the research firm Gartner, outsourcing is the business area that will grow the most in years to come, with annual increases of about 20%. Those prospects may motivate Microsoft to take over Accenture, the largest independent consulting firm in the world, with sales of $11.5 billion. IDC is certain that this alliance would allow the group run by Bill Gates to make a definitive leap into the business market. At the moment, the greater part of Microsoft’s business is rooted in the consumer marketplace. Its purchase of software applications companies Great Plains and Navision are, in the opinion of IDC, clear illustrations of the interest that the company has in expanding its role in the business world. Moreover, this possible merger would give rise to the fifth-largest company in the information technology sector.
Overcoming the Rough Patch
For the moment, however, it appears that a new wave of mergers will have to wait. The main reason is because manufacturers as well as consulting firms have suffered from the collapse of the technology bubble and the overall weakness of the economy. Manufacturers made heavy investments in new technologies that wound up weighing down their financial results. Consulting firms allowed themselves to be overtaken by the Internet euphoria, and then paid for the consequences of excessive staff, falling prices and reduced margins.
“In the year 2000, at the height of the dot-com bubble, consulting firms had real problems hiring and retaining personnel,” Weber recalls. “This situation is going to [repeat itself] when the market gets strong again. In fact, companies have not stopped hiring new personnel because they know that, to the degree that the economy recovers, demand for staff is going to shoot up and they will have to be prepared.” Weber isn’t talking about a business ‘recovery,’ but about “an authentic boom. Today companies have stopped their large-scale projects because they prefer to be cautious. But they can’t go for long without making investments because they will lose their competitiveness.” Facing this situation, Weber predicts that “the market can’t wait much more than a year and a half.”
At that point, a boom in technology will take place once again, Weber says. “After two difficult years, Internet companies are beginning to harvest the fruit and demonstrate that they can be profitable. This is going to mean that, to the degree that companies start investing again, they will do so with full force in the field of new technologies. And the consultants will be there to absorb the demand.”
Those signals will lead technology manufacturers to step on the accelerator pedal. “You have to realize that, of the three factors noted above, one factor is responsive to cycles – the fall in contracts as a result of the economic situation. But now, we are facing a new outlook.” Weber is referring to the consolidation of the sector after the divorce of consultancy firms. This future will change radically as far as both sales and service contracts are concerned.
“It will go beyond outsourcing. It is what some experts are already calling ‘e-utilities,’” Weber says. “Services for consulting and technology will wind up converging in a new business model similar to what we already know in telephony. They charge you for the use that you make of the telephone line, not for the telephone.”