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One of the attractions of IT outsourcing (ITO) for buyers has been the capital infusion they receive if the service provider purchases their current IT infrastructure. The sale of older computers frees up capital for mission-critical core functions while the outsourcing initiative itself makes the most up-to-date technology available.

Service providers could afford to purchase the assets of their buyers because the providers had better access to capital. Until the dot-com bust, major IT service providers had stellar Moody's ratings on their debt. As double A-rated companies, they had better access to capital than many of their customers.

The public's increased scrutiny of accounting at these public companies has caused several of these firms to rethink this business model, especially those that use "point of completion," a routine accounting practice.

Accounting Practice Affects Stock Price

Here's how point-of-completion accounting works. Often, outsourcing contracts have large transformational initiatives that create new processes or IT infrastructure for a customer. These arrangements often do not allow the outsourcing provider to bill the customer until the initiative is complete and functioning. Point-of-completion accounting allows the service provider to recognize that revenue over the life of the contract instead of in the years it is billed.

For example, say a service provider needs two years to build the infrastructure for a buyer. The cost is $100 million. Once the technology is operational, the buyer agrees to pay $50 million a year for the services. In the next three years, the service provider earns $150 million with little expense.

Instead of recognizing a $50 million loss in years one and two, and $150 million profit in years three through five, point-of-completion rules allow the service provider to recognize $30 million in revenue each year over the life of the five-year contract. Assuming the infrastructure is depreciated, the expense is $20 million per year; and revenue and expense match neatly, as Generally Accepted Accounting Principles (GAAP) would encourage any good accountant to do.

This use of accounting was a good thing for these publicly traded companies. One of the main tenets of American capitalism is that the stock price of a company reflects its economic health. Booking income in the first two years of the contract helped boost the earnings of these companies and, hence, their stock valuation. For that reason, some of the major ITO players adopted this method of accounting for their cost-heavy front-end projects.

However, estimating the margin on these contracts is an inexact science at best and recognizing earning in this manner can create a potential liability. What if the buyer had been Enron or WorldComm? The customer might not be around to pay the bills when they come due.

Investors now worry that the per share earnings of the ITO service providers may be inaccurate. Did the company really earn 50 cents a share? Or, if you back out the point-of-completion numbers, was the real number just two cents a share?

What This Means for Buyers

These questions, along with the general economic downturn and the bear market, have hurt ITO service provider stock prices. Many are trading in single-digit multiples for the first time in their existence. These factors have also hurt their credit rating.

Today, the service providers aren't routinely purchasing the infrastructure of their buyers. In addition, they are detailing the transformational initiatives and asking the buyer to pay for them separately from the outsourcing arrangements. Buyers without strong financial health aren't finding service providers willing to do the types of deals that were common a few years ago.

The reality is, companies who have been slow to embrace IT outsourcing are finding they can't find the sort of arrangement that they were offered a few years before. This changing ITO world increases the importance of using a trusted intermediary who can help buyers through this new landscape. Firms like the Everest Group can help you assess your situation, your objectives and match you with a service provider that is likely to meet all your needs.

Lessons from the Outsourcing Journal:

• The ITO landscape is changing. Service providers today don't have ready access to cheap capital like they used to. That means they aren't as able to give the buyer a capital infusion by buying its IT infrastructure.
• Investors are now questioning an ITO service provider accounting practice called point of completion. They are demanding a more accurate reporting of actual revenue.
• Buyers with lower credit ratings benefit from using an intermediary to ensure their IT outsourcing deal meets their needs in this tougher market.

Publish Date: March 2003

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Copyright © 2003 - Everest Partners, L.P.

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