Growing rift between enterprises and service providers

As the services industry shifts into a digital world, there is a growing misalignment in interests among service providers, their critical stakeholders and investors, and their clients. Why should clients care about this growing rift with their service providers? Because it changes the service providers’ investments and commitment. Here’s what I see clearly happening.

In a nutshell, clients are voting through their wallets and basically forcing the service providers into a digital business model. And they’re being very clear: if the existing providers don’t want to change to a digital business model, they will switch to providers that do. But at least initially, the new digital models don’t yield the same profit margins as the providers’ longstanding labor arbitrage model.

Profit margins in the mature labor arbitrage space have been historically abnormally high. Service providers have enjoyed gross margins in the 40 percent range and net margins in the 20s. But the new digital models are not yielding 40 percent gross margins. (I want to be clear that I’m talking about service models that don’t have intellectual property (IP) ownership. When you move to IP/software ownership, you can get high gross margins in the 80+ percent range and profit margins in 40+ percent. But in this blog post, I’m referring to service firms, not IP firms.)

Several factors account for the difference in profit margins in the arbitrage and digital models. First, the compensation providers must pay for digital expertise skills. In addition, there is an increase in costs because of the necessity of placing talent resources close to the client business (usually onshore) and using consistent, persistent teams instead of the leveraged teams in the arbitrage factory model depending on churning lower-level talent.

Currently, client companies are not moving all their work into the digital model. But they largely put their new work into it. They increasingly want to adopt new service models. So, service providers need to move the new digital models if they want to grow fast. This sets up a disconnect. Providers are reluctant to shift to the new model because it’s less profitable, and it requires a significant amount of change. Those that are forced into the digital model because of client demands then face a disconnect with their investors.

The investors want the service providers to run cash to the shareholders. If the digital work is less profitably, they prefer that the providers grow their business by using their capital to consolidate the more profitable labor arbitrage space. Investors don’t want them to waste capital by investing in a riskier, less profitable space.

So, we have misalignments among clients, service providers and investors. The investors naturally want high margins and cash returns, whereas the service providers that are chasing the digital space want to not return cash and, instead, use it to buy digital companies and move into the fast-growing digital space.

Returning cash to shareholders and consolidating the arbitrage space is a short-term return. Long term, if providers want to survive over a 10-20-year horizon, they need to move into the digital space. Client companies tend to be much more long-term oriented than investors.

It is very difficult to switch to new business models. The only service provider that has successfully shifted business models more than once is IBM. It appears Big Blue is attempting to do again. But it’s a very hard thing to do, even for IBM.

For clients, the wrestling matches between providers and their investors underline the importance of choosing service providers whose investors are committed to the new digital models. I believe this is a strong driver for large enterprises increasingly choosing smaller, newer service firms for the new work going into digital models. Bottom line: Smaller service providers (which normally would be perceived as higher-risk partners) are less risky because they understand the new model and they don’t have investor constraints pushing them the other way.