June 2010 Newsletter : Service Leadership

Readying for a Rebound
Tips for Your Specific Business Model

There are ten Predominant Business Models (PBMs) in the Solution Provider world, five focused on infrastructure, four on applications and one for Product-Centric.

Each responded differently as the recession started and then deepened, and each will respond differently as the recession ends as the economy accelerates. Here are our tips for Solution Provider owners and executives in each Infrastructure-centric PBM to maximize your rebound for best results.

(For a reminder of how Service Leadership determines your Predominant Business Model©, and why it’s beneficial to know, and how to know what yours is, go to www.service-leadership.com/pbm/index.asp.)

The chart shows how each Predominant Business Model performed differently during the recession and as the economy recovers. Note: Service Leadership normalizes the profit data to neutralize private company owner compensation differences.

PBM: Infrastructure-Managed Services

At the start of 2010, just over 20% of Solution providers in North America had a PBM of Infrastructure Managed Services (Infra-MS) (up from just 5.1% in 2006). This means that Managed Services is a large enough part of their business that management will tend to favor it in their decision-making, and economic factors influencing Managed Services will impact these members the most.

As the chart shows (red line), the Infra-MS PBM over the eight quarters of 2008 and 2009 has shown the most consistent decline of all PBMs, across all S-L Index populations. It did not show the deepest decline, which is consistent with the more durable nature of recurring revenue compared to other business models.

Clients trimmed expense budgets even if they were happy with the service, and also reduced headcount; both of these factors impacted Managed Services fees. In addition, prospects were slower to decide on committing to new recurring expenses. These factors hit Infra-MS companies hardest. In addition, the constant influx of newer Infra-MS companies, who have less experience at holding profitable prices, created a temporary low "market price" which some Infra-MS firms felt compelled to match.

Infra-MS Opportunities in a Rebound

Here are profit opportunities for Infra-MS companies in a rebounding economy:

New contract signings should accelerate. Companies tend to outsource more when business is accelerating, in order to keep up with growth while not distracting themselves from their accelerating core business.
Companies will be adding to headcount, so be sure to make clear that each new user and device adds to the monthly fee.
While decision-makers are feeling optimistic about the future, take the opportunity to offer contract extensions; close multi-year deals now as a way to increase your stock value and defend against unexpected downturns.
While capital expense budgets are freeing up, and executives are worried about productivity, encourage them to refresh old machines and replace them with highly manageable machines, such as those with Intel vPro technology to reduce your support cost and increase user productivity.
Scan the web for:
- "Want ads" for hiring new IT employees.
- Indications of incubator-style business start-up concentrations.
When businesses expect change, they need more IT planning; now is the time to step up your QBRs and let them know you're supporting their growth. It's also the best way to harvest projects.

Infra-MS Cautions in a Rebound

Here are things Infra-MS companies should keep an eye on in a rebounding economy:

Some companies who are nearly big enough to afford an IT staff but don't have one now, may decide to take the big step and replace you with new IT staff, if they're expecting growth. This is the other, defensive reason to step up your QBRs now.
Expect a wave of projects as pent-up demand for new equipment and new technology such as Windows 7 starts to become affordable again. This means your project team may become over-stressed and your support team will experience an influx of demand from new technology waves going into the installed base. If you haven't decided what the next generation of your standard client technology footprint looks like, decide soon and start promoting with your clients now, before the come to their own conclusion about what it should look like.

PBM: Product-Centric

The second largest population of Solution providers in North America is of Product-Centric companies (17.5%). Companies in this PBM are primarily in the business of reselling product; they will tend to make decisions which favor product volume and profitability.

As the chart shows, Product-Centric (purple line) companies decelerated strongly in Q4-2008, as did virtually all SP business models, and then recovered fairly quickly, only to have a weak Q4-2009 (again similar to the other business models).

Gross margin production in Product-Centric firms is less dependent on the number of employees than in services-centric firms, and therefore when sales slow there is often less need to reduce headcount. As a result, there is less exposure to extended cost overhangs, and so the swing in profitability is narrower than in the service-centric business models. Put another way, it is somewhat easier for a Product-Centric firm to hunker down and ride-out a downturn, simply because more COGS dissipates with a drop in revenue than in services firms.

Product-Centric Opportunities in a Rebound

Here are profit opportunities for Product-Centric companies in a rebounding economy:

Suppressed demand for capital equipment will likely be freed up. Expect increased demand across all product categories, but especially among workstations and laptops to take advantage of Windows 7.
To the extent you are providing technical services or sales engineering services at no cost or reduced cost to big product buyers; plan to claw those concessions back as expense purse-strings loosen. This is way to increase your overall gross margin without actually increasing product prices.
As product vendors seek to maximize the upturn, work closely with your chosen ones to leverage their program benefits as much as possible. Use a Memorandum of Understanding approach to secure a customized relationship.
Cloud services, especially those from major branded vendors, will likely be the easiest services for your sales team to learn to sell. They represent your best offense in years against services-centric Solution Providers poaching your clients. Take a good look at vendor-branded cloud services and start testing the water to get your sales team accustomed to selling them now.

Product-Centric Cautions in a Rebound

The primary caution for Product-Centric Solution Providers is not so much related to the economy as to cloud services, which represent the largest threat to the entire Solution Provider community since the decline in product margins in the late 1980's and early 1990's to the low level still experienced today.

To the degree that cloud services are successful, capital equipment purchase decisions will shift with some speed from the end customers to the providers of the cloud services themselves.

This is likely to have a significant impact on all Solution Provider business models, but on Product-Centric ones most of all. As margins on product declined, Product-Centric firms focused away from selling PCs and more and more on selling the larger dollar "non-commodity" items such as servers, storage, core networking gear, and so on. Heavy equipment is, so to speak, the last bastion of the Product-Centric firm. Cloud services represent the evaporation of specifically that equipment, up out of the customer's premise and into the sky.

Presumably, in a pure cloud world, one has a laptop with a WiMax connection and…that's it. The company's production applications live on virtualized servers running on hardware whose purchase was decided by someone far away.

There is potentially some light at the end of this tunnel.

As noted in the Opportunities section, cloud services from today's large IT vendors are likely to be the easiest services for product-centric sales reps to sell. In contrast, service-centric firms are more likely to be attracted to white label cloud services to which they can add more value. As a result, we expect Product-Centric firms to become champions of branded cloud services, doing battle against services-centric firms aggregating white label ones, but in this battle we expect the Product-Centric firms to have an unaccustomed advantage.

While they will still have less of the consultative selling skills that service-centric firms have, the Product-Centric firms are structured to survive at 10% to 15% margins (where we expect vendor-branded cloud services to settle). Services-centric firms are structured to survive with the 45% to 55% margins customary to their self-delivered services, but they will only be getting perhaps 30% margin from the white-label cloud services they will choose to sell.

So while Product-Centric firms will "merely" have to deal with getting their customary (low) margins from the new services, service-centric firms will be faced with a much greater challenge: letting service people go and learning to live on margins half (or less) of their customary richness.

Historically, services-centric firms have been able to increase margins by operating more efficiently. Cloud services are essentially a product to be purchased at one price and sold at another, and operational efficiency has little to do with the resulting margin.

In effect, the cloud services revolution will turn service-centric Solution Provider largely back into Product-Centric ones. Call it Revenge of the Product Resellers, and you wouldn't be far off.

Three caveats for Product-Centric firms, though.

First, Product-Centric firms love selling big deals, and their attendant flood of gross margin dollars. In contrast, selling a virtualized server in someone's cloud yields less cash up front. Cloud services turn capital expenses into operating ones, that is, into annuity revenue for a Product-Centric firm that will have to get used to a steady stream of small gross margin dollars rather than a single big flush of gross margin, and so will its sales reps.

Second, not all Product-Centric firms can sell vendor-delivered services, even when they are highly productized. A good example is vendor maintenance contracts. Even when the gross margin on the maintenance contract is twice that of the product itself, the proportion of channel partners selling any given vendor's maintenance contracts is well under 50%, and the 80/20 (or even 90/10) rule holds true. In short, if your team isn't selling the vendor's maintenance contracts now, it would be a good time to get the accustomed to it, because vendor-branded cloud services are likely to feel largely the same.

Third, we mentioned that services-centric firms will likely choose to sell white-label cloud services instead of vendor-branded services. Services-centric firms generally develop two capabilities which enable them to do this:

They are more comfortable selling their own brand (and less comfortable selling a vendor's),
They have services coordination capabilities which allow them to add value to a suite of multi-sourced cloud services by integrating them into a more seamless whole and managing then performance of the cloud vendors behind them.

These will be the competitive advantages that services-centric firms will have in selling against your vendor-branded cloud services. That said, they will have wrenching changes to make to deal with the loss of no-longer-needed service people, lower gross margins and – ultimately – selling a set of cloud services that are much less flexible than their own services they are accustomed to selling.

PBM: Infrastructure Technical Services

The third largest population of Solution Providers in North America is of Infrastructure Technical Services companies (12.2%). Companies in this PBM are primarily focused on providing time and materials support of various kinds; flat fee Managed Services and projects are smaller portions of their revenue. They will tend to make decisions which favor T&M services profitability.

As the chart shows, Infra-TS (blue line) decelerated sharply in Q4-2008 as clients severely trimmed discretionary expenses. Then Infra-TS accelerated faster and farther in the first three quarters of 2009 than any other PBM, with clients finding it easier to make short term T&M expense decisions than the larger and longer commitments needed for the other business models.

The fourth quarter of 2009 saw a sharp drop in Infra-TS profits, along with essentially all other PBMs, as the wind in the sails of the previous few quarters died off. We are awaiting Q1-2010 results.

Infra-TS Opportunities in a Rebound

Here are profit opportunities for Infra-TS companies in a rebounding economy:

Take this opportunity to increase your hourly rates: according to our annual Solution Provider compensation benchmarks, salaries for Solution Provider employees rose over 8% between 2007 and 2009. If you have not increased your rates in several years, soon will be the time.
Companies will tend to increase their demands for responsiveness their need for productivity increases and their expense purse-strings loosen. If you do not have one already, set up a tiered T&M rate structure based on response time. Generally speaking, your lowest rate per hour should be pre-scheduled time. One notch up on the rate scale should be third- or second-day response, and the highest rate per hour should be same day, or evening and off-hours work, which should be about double the pre-scheduled (lowest) rate. If the customer objects, this is one more reason they should buy Managed Services, but in the meantime, at least you have a profitable response time policy.
As always, make sure your travel time fees are being enforced.
If you are selling blocks of time (retainer), take three steps:
- Engage in more proactive work to ensure the users' productivity but also consume the time block more quickly,
- Institute a use-it-or-lose it policy to accelerate your revenue recognition and avoid unfunded liabilities on your balance sheet which can diminish valuation and financial flexibility,
- Increase your minimum block size, to increase the efficiency of your sales team.
Scan the web for:
- "Want ads" for hiring new IT employees.
- Indications of incubator-style business start-up concentrations.

Infra-TS Cautions in a Rebound

Here are things Infra-TS companies should keep an eye on in a rebounding economy:

Expect requests for wage increases as employment rises. We're probably still a ways from significant hiring pressure, but now would be the time to implement an incentive-based plan which enables you to keep increases corralled to the incentive side of the compensation plan, rather than the base-salary side.
In Infra-TS companies, the client can become bonded to a specific engineer on your team, rather than to your company, exposing you to risk of losing the customer if your tech leaves or joins them. Do what Infra-MS companies do and bond the customer to your processes, that is, to the service team and its customer care process by taking steps to make it possible for everyone on the team to interact productively with the client. Not only will they get better service, but you can start to substitute lower cost labor for some activities, and the customer will have a better sense that it is your team, your company that provides the value, not just their "favorite tech". First step: force the customer to call your help or dispatch desk, not your engineer directly.

PBM: Infrastructure-Project Services

The fourth largest population of Solution provider in North America is Infra-Project Services (6.2%). These are firms whose primary profitability comes from implementing new systems (or upgrades) in engagements that are Scope of Work driven rather then SLA (managed Services) or work order (T&M) driven. These firms will tend to make decision which favor keeping project teams utilized, preferably on large projects with minimal lag between them.

As the chart shows, Infra-PS firms (orange line) accelerated strongly during the first three quarters of 2008, as clients continued to evolve their infrastructure but avoided hiring IT workers. However, in Q4-2008, when customer severely clamped down on capital expenses, Infra-PS firms got hurt the worst of all PBMs.

This is normal: usually Product-Centric and Infra-PS firms suffer the most when capital spending declines. However, as noted before, in a Product-Centric firm, COGS stops when sales stops, but in a Project-Centric firm, the project engineers stay on even when no projects are being sold.

Hence, in Q4-2008, while Product-Centric firms caught a cold, dropping to 0.8% profit, Infra-PS firms got pneumonia, dropping to negative 2.8% profit.

Happily, in an accelerating economy, Infra-PS firms usually do well. An extreme example of this took place in 1999, when the overall economy, plus the (first) internet boom, plus the y2k "crisis" conspired to form a perfect storm of profit for Infra-PS firms: massive infrastructure replacement and build-up.

Infrastructure Project Services Opportunities in a Rebound

Here are profit opportunities for Infra-PS companies in a rebounding economy:

Mirroring Product-Centric firms, pent-up demand should create a significant burst of implementation activity.
Work now to streamline and "accuratize" your scoping process. A steady stream of projects can break an Infra-PS firm if they come in over budget and late. Measure past overruns and adjust future scopes upward by an equal proportion, until your scopes are deadly accurate. Each individual project must attain 2.5 x wages or better and the project team in aggregate across all projects and solutions must do so, too.
Hone your project methodology and train everyone on it, as well as your project control methodology, so that you can bring in contract workers to meet project demand and avoid undue permanent staffing.
Tune your marketing to emphasize that your solutions allow increased productivity without increased hiring (since employers are still shy) but be ready to flip that message into: "Be ready for the influx of new employees" quickly.
There are more and more Infra-MS firms who elect not to do projects because many of the optimization techniques needed for project team profitability and for MS-team profitability conflict with each other. Free yourself from the dread post-install support requirement by partnering with an Infra-MS firm who doesn't like to do projects.
Aging equipment means more likely wholesale replacement than upgrading the existing box, so be up to snuff on your selected "new technology" solutions.

Infra-PS Cautions in a Rebound

Here are things Infra-PS companies should keep an eye on in a rebounding economy:

One common pitfall among Infra-PS firms in expanding economies is taking on too many different solutions and/or vendors. In general, there is an inverse correlation between the number of solutions offered and the gross margin profitability of the projects team. This is because project teams are most profitable when they are designing and installing cleanly and crisply, which is harder to do the more solutions there are in the "portfolio". Pick your few solution "horses" and ride them, do not be tempted to have a whole herd.
Another common pitfall is staffing up too far. Infra-PS firms are second only to Infra-MS firms in their need for methodology and adherence to it. There is a strong temptation to hire so that methodology trained is methodology retained. However, the typical tech in an Infra-MS firm costs $10,000 to $40,000 less per year than a typical project engineer, and the revenue is more predictable, so over-staffing is more "tolerable" in an Infra-MS firm. In Infra-PS firm, it can lead to a sudden arrest of profits. As noted above, build your methodology around a core group of senior, employed engineers with teams of junior, contracted engineers. Do not hire permanently until both of the following conditions are true: a) the hiring market has tightened up considerably (think mid-2007) and b) three contractors are billing flat out for every one person you are tempted to bring on full-time.

PBM: Infrastructure-Balanced

The fifth largest population of Solution Providers in North American is of Infrastructure Balanced companies (3.8%). Companies in this PBM have at least two of the aforementioned lines of infrastructure services that are approximately equal in size, and possibly all three about equal in size.

As the chart shows, Infra-Balanced firms (green line), decelerated early, as did Managed Services firms, but then accelerated in Q4-2008 when all other business models were still decelerating. Coming into Q1-09, they continued to accelerate albeit somewhat unevenly.

Overall, this PBM has shown the least decline and most consistent improvement of all. This is because – unlike the other business models who consciously or unconsciously make it harder for prospects to buy non-core services – Infrastructure Balanced firms more eagerly say "Yes" to whichever service the prospect wants to consume at the time.

This is obviously not a free for all, but by definition the Infra-Balanced firms have a responsibility to feed mouths which are more evenly distributed across the lines of business and so are more adept at closing a deal across more opportunities than more pure play firms. In a down market, this is likely to be a more robust business model, because a higher proportion of prospects can be converted to clients.

That said, running an Infra-Balanced firm is concomitantly more difficult; it requires master of multiple business models and dealing with them in contention with each other, whereas the closer one gets to a pure play in the other PBMs, the more one can focus on getting good at a narrower range of activities.

In terms of opportunities and cautions, the executive of the Infra-Balanced firm can read those of the other, constituent lines of business in this article and apply them as desired.

Closing Thoughts

As the saying goes, what doesn't kill you makes you stronger. No question most Solution Provider owners and executives are stronger managers now than in Q3-2007, the last peak of the IT economy. You are lean and mean and poised for profit, and you will have earned it.

Because of this Spartan training, generally speaking, all PBMs do well profit-wise in the first quarter or so of an economic recovery. However, in subsequent quarters profit margins tend to shrink even as revenues continue to grow, because we forget the Spartan way.

Hopefully, the first signs of an economic spring are budding, yet there are many unknowns in our current course, both micro-economically in the Solution Provider business and macro-economically. Our advice is to stay in condition.

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