Discretionary IT projects are getting the ax as companies review costs, hurting sales and growth for outsourcing providers

The economic slump has become so pronounced that even outsourcing is getting scaled back. Executives who once relied on outside firms to handle certain IT tasks to cut costs are now reining in some outsourcing plans on concern they’re too expensive. Just ask Steve Budny, director of global outsourcing at Oceaneering, a supplier of equipment and engineering services used in the offshore oil and gas industry. While Oceaneering (OII) itself has not seen a massive demand slowdown, it’s nonetheless taking preemptive measures to wring savings, Budny says. The Houston-based company has shelved certain IT projects and curtailed some outsourcing in India. “We haven’t given up doing things over there, but we’re doing things differently in the short term,” he says.

Oceaneering isn’t alone in reconsidering the role of outsourcing in light of the global economic crisis. While companies are still spending on outsourced projects to run basic IT systems, they’re cutting the cord on discretionary arrangements, says Avinash Vashistha, chief executive of outsourcing advisory firm Tholons. The reexamination is eroding sales for a range of companies that provide IT services and hampering growth in traditional outsourcing hubs, such as areas of India.

Conventional wisdom says that companies tend to outsource more as growth contracts. While that’s often the case at the end of a recession, experts say the opposite may be true early on, as companies scramble to respond to rapid changes in economic conditions. Only when executives foresee a rebound do they ramp up outsourcing; the aim is to build resources without hiring. “We’ve been in a soft outsourcing market for arguably six months,” says Peter Allen, partner and managing director of sourcing advisory firm Technology Partners International (TPI). He doesn’t expect that to change for at least the next three to six months.

“Perfect Storm” of Troubles for India

India has been particularly hard hit during this recession since about 60% of its outsourcing contracts come from U.S. companies, many of which have been struggling. First the global credit crisis escalated in September. Then the November Mumbai terror attacks made U.S. companies briefly worry about India’s long-term security as an outsourcing destination.

Less than two months later, a financial scandal rocked Satyam (SAY), India’s fourth-largest outsourcing provider, leaving the future of that company uncertain and raising questions about whether there is enough regulatory oversight of India-based outsourcing providers. “There is a perfect storm centered over India,” TPI’s Allen says.

While the Indian outsourcing market is still growing, the pace of expansion has dropped dramatically in recent years. After expanding by 35% in 2007, it slowed to about 15% growth in 2008, says Tholons’ Vashistha. The firm expects growth to taper off further, to 6% or 7%, in 2009.

Some companies are opting against signing new contracts. Others are looking to renegotiate existing arrangements. “Even if you went back as late as September, it was still a seller’s market,” says Christine Ferrusi Ross, research director at Forrester Research (FORR). But that has changed quickly, and India is now a buyer’s market where customers have much more power to negotiate better rates and better service terms. Forrester clients are calling vendors that provide labor and demanding a discount or renegotiating contracts.

“Depending on how strong the account is, some of the Fortune 50 companies that have revenue of $10 billion-plus are calling and saying, ‘You’ve got to take rates down 10% to 15% if you want to work with us,’” Ross says.

Outsourcing’s Boom Quickly Fades

Even smaller firms are pushing for—and getting—discounts. Vizu, a San Francisco-based online media measurement company with 15 employees, recently went back to an outsourcing firm based in India after a break of about two years. “We started up two months ago and they quoted us a price that was similar to last time but we negotiated 25% less,” says Vizu CEO Dan Beltramo. However, Ross says, companies need to be careful that the deal is fair to both parties; otherwise they may end up with a poorer quality of work.

Last year at this time, the outsourcing industry was booming. As recently as six months ago, clients were worried about rate inflation in offshore outsourcing deals. Some fretted whether first-tier Indian providers would even agree to do their projects, Ross says. In India, employee wages were rising and turnover was increasing as demand for labor outstripped supply. That, combined with unfavorable exchange rates for U.S. companies, gave many companies incentive to try other global destinations, in Latin America and elsewhere.

Two years ago in Bangalore, financial and health-care software company Misys (MSY.L) had employee turnover rates of 30% and higher at the offshore center it runs there. By the most recent quarter, the rate had plummeted to zero. “I’ve been doing business as a software professional in India for 20 years and I’ve never seen attrition levels at zero,” says Cory Eaves, CIO and CTO for Misys, which has more than 6,000 employees worldwide. Eaves says that for the past few years, wage inflation in India has been about 15% to 17%, and for 2009 he estimates that will go down to 7%. “2009 will be a challenging year for India,” he says.

Slump May Outlast That of the Dot-Com Bust

This year may not go down well in Russia either. A year ago, the market for software engineers had grown so tight that Russian outsourcing provider Luxoft began looking for more affordable talent outside Moscow. In 2007, Luxoft had 60% growth and in 2008 that slowed a bit, to about 40%. This year, the company will grow about 10% to 15%, says Luxoft CEO Dmitry Loschinin. These days, Luxoft has no trouble finding talent in Moscow, where wages are down 10% to 15%, he says.

Outsourcing specialists say this slump may last longer than the one associated with the dot-com bust of the early part of the decade. They base that gloomy forecast on trends during the second half of 2008, when the number of mega-deals worth more than $1 billion dropped to three, worth a total of $6.5 billion. That was down from 12 mega-deals, worth more than $17 billion, in the first half of 2008, according to TPI. The performance is comparable to that of the first half of 1995, when only two mega-deals were awarded, and it’s more pronounced than in 2001, TPI’s Allen says. “Unlike 2001, when there was only one dampened half-year performance, we might see an extended slowdown through the first half of 2009,” he says. When outsourcing does pick up again, it could be a sign that the broader economy is about to recover.

Despite the softness crimping overall sales in the industry, some providers, including Accenture (ACN), IBM (IBM), and Infosys (INFY), are holding up relatively well. In the fourth quarter, Accenture booked $2.24 billion in new outsourcing deals. That was a sharp decline from the very strong period that ended Aug. 31, but wasn’t far from the year-earlier quarter, when new outsourcing bookings came in at $2.5 billion. There was a “deer in the headlights” effect among corporate clients during the economic meltdown in September and October, but business started to pick up at the end of the year, says Kevin Campbell, group chief executive for outsourcing at Accenture.

Companies Try Outcome-Based Outsourcing

In January, IBM and Infosys both beat quarterly earnings expectations. In the fourth quarter, IBM added new outsourcing clients including Sara Lee (SLE), Korean Air, LendingTree (TREE), Fluor (FLR), and others. Even though Infosys exceeded analysts’ forecasts, the company did ratchet down its growth outlook. The company now expects sales growth of 12% to 13%, down from an earlier forecast for growth of 19% to 21%. And while much of the revision relates to currency fluctuations, it’s partly related to price pressure. During a Jan. 13 earnings conference call, the company said some customers were facing trouble and asking for price reductions. “We are seeing at least in some occasions, competitors cutting price globally and offshore,” said Infosys COO S.D. Shibulal.

In the interest of lowering the cost of outsourcing, some companies are moving toward what’s known as outcome-based outsourcing, which is based not on the number of hours it takes to do a task but rather on the results achieved. Norwegian Cruise Line went this route when it signed a five-year deal in September for IBM to manage its reservation system. CIO Vincent Cirel says he wanted to lower the total costs associated with that system. A team of eight to 10 people from both companies spent several months creating a deal that would include service-level agreements yet be flexible enough to meet the company’s needs, Cirel says.

Part of the agreement was the ability to dial the work up or down in light of demand. “As fate would have it, about three to four weeks after we signed the statement of work, the economy ran off a cliff,” Cirel says. “We didn’t plan to test it in this way or in this short a period of time, but the statement of work passed the test,” giving Norwegian Cruise Line flexibility to ratchet down its demands. Using knowledge gleaned from working with Norwegian Cruise Line, IBM says it may create similar reservation services for other companies that would let the customer pay for the service on a per-reservation basis, says Bruce Speechley, a partner in global business services, airlines, and hospitality at IBM.

As Oceaneering’s Budny was cutting back some outsourcing work, he also planned to leave some tasks with his offshore outsourcing provider, Satyam. Then, on Jan. 7, Satyam’s chairman resigned after admitting to financial fraud. “We didn’t see it coming,” says Budny, who adds that Oceaneering always enjoyed a good relationship with Satyam. Satyam’s chairman was later arrested and the government of India stepped in to replace its board of directors. Still, that day set in motion a 10-day scramble as Oceaneering employees drafted a Plan B. While some Satyam clients are still waiting to see how the situation unfolds, Oceaneering ultimately decided to find another partner. Says Budny: “There’s too much uncertainty and we weren’t willing to put ourselves at that level of risk.”