IBM Shows H-P How to Serve Clients

MARCH 8, 2011   the wall street journal

By ROLFE WINKLER

You wouldn't know it from Hewlett-Packard's most recent results, but as the economy picks up steam, technology's consultants and outsourcers are again doing brisk business. Still, considering valuations and volatility, investors must tread carefully if they wade into the sector.

H-P's services revenue fell 2% in the fourth quarter compared with the prior year, a contrast to rivals like International Business Machines, which saw services revenue rise 2%; Accenture, 12%; and Indian firms Infosys Technologies and Wipro, 29% and 19%, respectively, according to Goldman Sachs.

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These different growth rates highlight the dissimilar business models. But they also expose H-P's weaknesses.

Broadly speaking, technology services break down into two categories, outsourcing and consulting. Outsourcing firms are low-margin, labor-intensive "body shops" that often do run-of-the-mill tech support for office workers or manage data centers. Consultants do higher-level strategy work, redesigning supply chains or getting complicated software packages installed.

After buying body-shop EDS in 2008, H-P tends more to low-margin outsourcing. But growth is happening higher up the food chain in consulting, an area in which H-P is more of a marginal player. Indeed, on its last earnings call, CEO Leo Apotheker said H-P's performance has been weak in higher-value services. Meanwhile, price pressures continue to weigh on outsourcing, and H-P's lack of cheap offshore labor puts it at a disadvantage.

IBM made a better, earlier bet when it bought the consulting business of PricewaterhouseCoopers in 2002. With IBM's sophisticated software portfolio thrown in, its army of consultants is able to bid for more complex, higher-margin projects. To be sure, IBM also has an outsourcing business, which, like H-P's, faces increasing competitive pressure. But because of its heavy exposure to software, which often is installed by its consultants, IBM has much better pretax profit margins, 24% overall in the most recent quarter compared with H-P's 11%.

Even better-positioned firms aren't immune to recessions, however. IBM's services revenue dropped 7% in 2009, for instance.

Growth has returned as the economy has recovered. Even so, such volatility should give investors pause as they consider valuations above 20 times earnings for the Indian firms. IBM's 13 times multiple looks more reasonable, but its valuation relative to large-cap tech peers actually is at its highest level since 2002, said Bernstein analyst Toni Sacconaghi in a recent note to clients. And expected annual growth of 5% the next two years is modest.

For its part, H-P has some catching up to do. It has an impressive portfolio of data-center gear that it can sell along with services, but its software portfolio is meager compared with IBM's. And software is a crucial component of higher-margin deals. IBM has been building its software business for years. H-P may require a similar amount of time.

Write to Rolfe Winkler at rolfe.winkler@wsj.com