SERVICES 1997: A good vintage

Last year may have been successful for the software and services sector, but if companies don't find a way to sustain their prosperity, it will be shortlived.

If Frank Sinatra had still been around to croon, he would havees sector, but if companies don't find a way to sustain their prosperity, it will be shortlived. doubtless confirmed that 1997 was a very good year - at least for most of the UK's computer and software industry.

Dealers might be feeling the pinch from falling hardware margins and Vars might be struggling not to perish in the shifting sands of change, but otherwise few people in the industry should have had reason to moan.

That's according to analyst Richard Holway, who for the past 11 years has chronicled the sector's fortunes in his annual report and earlier this summer led a CSSA conference on the subject. His latest study reveals that not only was 1997 a very good year, but it also set something of a record with overall revenues for the UK software and computing services industry (SCSI) expanding by more than a fifth to #13.2 billion, foreign earnings shooting up by an even more impressive 42 per cent and the general profitability of UK companies increased by a third.

The sad news is that while Ol' Blue Eyes might have marked his very good years according to warm summer nights and dancing on the green, such activities for your average SCSI boss might have seemed a bit racy. As Holway points out, Britain's most profitable software and services companies also happen to be lamentably sombre and steady, so much so that he's instigated his own 'Boring Awards' to honour them, the main criterion being that the company must have had at least 10 years of uninterrupted growth.

So, forget sexy distributor Azlan, rocked by scandal over its financial reporting practices and whose shares plummeted as a result. As in the Confucius curse, it's lived through interesting times but that doesn't make it profitable. No trophies there: 'The company's far too exciting,' quips Holway.

Instead, step forward the likes of Admiral, Sage and Triad - companies all lacking in the notoriety stakes, but whose shares have soared 200 per cent or more in the past 12 months, making nonsense of the adage that virtue is its own reward.

Moreover, the prognosis for the good and the great, according to Holway, is that the next 12 months could be even better whatever the warnings of a global recession. He says: 'If you know your Bordeaux wine charts, you'll know that vintage years always go in pairs and then they're followed by four of five years of bloody awful times. By the same token, we believe 1998 for the IT industry will also be absolutely superb, but we're very fearful for the years after that.'

Not that 1997 has been without a few mixed bottles, some definitely sour.

This time last year, for instance, ex-IBM blue suit Barrie Morgans had just been appointed chairman of Azlan when its share price was 603p. Logica had issued a mild profit warning, causing its stock price to drop to 690p, while Royalblue's shares could be snapped up at just 170p.

But, as Holway points out, 12 months can make a hell of a difference.

Today, Morgans is no longer chairman and the company's financial reporting rumpus has seen its stock plunge of late to about the 48p mark. Meanwhile, Royalblue's shares are valued at 302p, with Logica's going through the roof at #16.15.

Holway paints a picture of an industry undergoing fast and furious change, albeit not always for the better. It's an industry in which the devil takes the hindmost, as mergers, MBOs and acquisitions rise to unprecedented levels.

But he also acknowledges that while the UK market is buoyant, it's not necessarily British companies that are benefiting. Indeed, in his roll call of the top 10 SCSI suppliers, only one - ICL - boasts a clear British pedigree.

But the irony is that ICL is now Japanese owned and, compared with the likes of EDS, IBM, Oracle and Microsoft who all increased their revenues by about a third last year, ICL's growth was a paltry eight per cent in 1997.

The good news is that in Holway's database of purely UK suppliers - where the likes of Logica and Sage hold sway - overseas revenues increased on average by 42 per cent, with European trade up 50 per cent and the rest of the world increasing by 28 per cent.

As for ICL, Holway comments: 'It's undoubtedly true that it hasn't been able to keep pace with the expanding market in its services activities.

'And some of the problems that it is currently facing - such as with the government Pathway project - are extremely concerning for the future.'

He adds: 'If anything happens to Pathway, you can wave goodbye to ICL's chances of flotation.'

Holway also admits that the financial performance of UK companies abroad has to be treated with caution, given how the strength of Sterling can inflate turnover figures and the fact that many overseas markets are on the increase anyway.

What isn't ambiguous, he adds, is how the home market is expanding, with the UK now ahead of France in terms of its ability to generate revenues and poised to overtake even Germany in the new millennium.

In terms of the highs and lows of the indigenous market, Holway says: 'The two markets that have declined in the past year are hardware maintenance and proprietary operating systems, which even the sales of Windows hasn't compensated for.'

By contrast, he points out, the general outsourcing market has slowed to 29 per cent, compared with a growth of 40 per cent in 1996. This, Holway attributes primarily to the lack of mega contracts from the likes of the Inland Revenue, while another once lucrative market - running a data centre or managing, say, a client's IBM mainframe operation - has similarly 'matured'.

'To be blunt, most outsourcing of data centres is now water under the bridge, which is why the industry has moved onto other areas such as business process outsourcing, where you take over a complete task like payroll or debt collection. Those areas are almost infinite in scale because, logically, if the independent services sector kept on expanding, it would take over the whole of British business,' he says.

It is against this backdrop of rapid change, however, that pure hardware dealers or those involved in peddling packaged software have to measure their own prospects. With margins on most PCs down to 10 per cent or less compared with 40 per cent on software, not to mention the opportunity the latter offers for consultancy work, the message seems clear: yesterday's tinmen have to migrate to the services sector if they're to survive.

Holway argues that in the past year, the industry's star performers have been the type of companies whose activities are people-intensive and where high levels of skill have commanded a premium.

Much of this, of course, has to do with the consultancy work generated by EMU and the year 2000 problem, with top UK companies involved in supplying IT staff witnessing a huge 56 per cent growth in turnover.

According to Holway, companies involved in bespoke development revenues have similarly seen their turnover leap by a third.

Such revenue increases means the private software and computing services industry now employs more than 600,000 people, significantly more than the number of staff working in-house and confirming the outsourcing trend.

Paradoxically, it's a trend that has not been accompanied by an overall rise in the wage bill for SCSI staff - directors, programmers and network managers perhaps excepted.

Holway's explanation for this is that while 44,000 people have been recruited to the industry in the past 12 months, many were inexperienced and recruited specifically to run call centres and helpdesks. With government IT departments increasingly going down the outsourcing route, significant numbers of clerical grades have also joined the industry workforce, suppressing wages and widening the skills mix.

But while Holway's latest report provides a macro view of how the industry is changing, what strategic advice does it hold for your average dealer?

In short, its recommendation to most is a simple one: although products will always be vital, the margins are now best found in providing consultancy and services. 'Forget searching for the next Microsoft,' Holway says.

'Services is definitely the route to go down.'

He predicts that within five years, less than half of Microsoft's revenues will come from product licences. Shrink-wrapped packages will be replaced by a new pricing model in which users are given the software for free and then charged per internet transaction - much in the same way that Compuserve and other ISPs bill customers.

'Just think about all the things Gates has bought into recently,' he says. 'Almost everything - from buying Autoguide in the UK to content-based services in the States - is geared to internet transaction activity.

'Ultimately, there won't even be a market where you can buy Microsoft software. But you'll use it and you'll pay for the service unless the service is free as well and then Microsoft will make its money out of related advertising.'

If Holway is right, it's not a development that bodes well for PC dealers or resellers who rely on selling software.

It also explains why tin manufacturers are shifting position. 'Why do you think Compaq bought Digital?' asks Holway. 'It's not because it wanted it for its hardware - it wanted a significant services organisation.

'Dealers and Vars have similarly got to change to another business model where they make their money by offering a very high quality service to customers, rather than having their business rooted in a third-party product, be it hardware or software. Otherwise, they will just go out of business - as many already have,' he adds.

But that's not to say the software suppliers will divest themselves of making programs, or reduce R&D. 'The product will remain as vital as ever,' predicts Holway, 'because without it these companies won't be able to levy fees for the service.'

He cites the case of accountancy software house Sage: 'It now makes 70 per cent of its revenues not from the sale of products, but from the support of those products.'

Holway warns: 'It's a business dynamic that people have got to get their heads around and those who can't or won't will have an extremely difficult problem in the future. I also think it will be Vars most likely to suffer because they haven't thought deeply enough about what is happening.'

THE INDUSTRY REPLIES

Industry gurus may lay down markers for the future, but how are they themselves perceived? We asked a number of industry players for their views on the Holway report:

Jason Rabbetts, business manager, Ideal Hardware 'I agree with Holway. This past year has definitely been good in terms of pure revenues, but it's also been a good year for people to decide how they're going to tackle the market.

'There's still margins to be made from products, but not as much as there used to be. At Ideal, we do more than #335 million a year in software, but nowadays we also do a lot of system selling.

'That may seem a recipe for upsetting our Vars, but only a few of them have got the resources to do the big outsourcing work anyway. Meanwhile, there's so much other business out there that they're not going short.'

He adds: 'But as for PC dealers whose whole livelihood is in selling tin, I'd agree with Holway - their days are numbered.'

Geoff Slyfield, president of CSSA and Tangent International 'The trend is towards services. You've only got to look at how the likes of IBM have repositioned themselves over the past few years.

'But you can't dismiss small companies that stick to selling just hardware and software - there are always plenty of start-ups to take the place of other companies that have been bought up or gone bust.'

John Talbot, sales manager of PC-to-AV distributor Gordon Audio Visual, Camden 'I agree that it's getting increasingly difficult to make money out of hardware and our margins are being attacked all the time.

'But we're not going into services, although selling video conferencing equipment is one area we're looking at. Otherwise, it's been a very patchy time - no one we know has made a fortune in the past year.'