FSN: Does outsourcing create shareholder value?

Does outsourcing create shareholder value?

4th July 2005
LogicaCMG a provider of outsourcing services produced a study at a press conference last week purporting to show a link between companies announcing an outsourcing deal and superior stock market valuation. Stock market values of companies that outsource some of their operations could be even higher, says LogicaCMG, if only they could communicate the benefits more convincingly to their shareholders. Gary Simon, managing editor of FSN newswire explains why the report could be more valuable for what it did not say rather than its published conclusions.

The first part of the LogicaCMG study, "Outsourcing for Corporate Value", analyses historical stock market data of companies that have announced outsourcing deals against companies in the same sector that have not announced deals.

In broad terms the study, conducted by the Centre for Economic and Business Research (cebr) analysed outsourcing announcements to the press and measured the change in share price one month later - measuring the result sector by sector. The findings showed that companies announcing an outsourcing deal perform on average 1.7 percent higher in the stock markets benchmarked against others in the same sector that have not announced outsourcing deals. However, this is not universally true. Banking, insurance and telecommunications companies showed poorer share price performance one month after making an outsourcing announcement.

Questions were raised at the press conference over the validity of choosing a one month review period. FSN contended that if share price and outsourcing were tightly coupled then a share price movement would be seen immediately after the announcement. Others commented that a one month snapshot said nothing about the long term sustainability of any possible positive effect on shareholder value.

The waters were further muddied by what exactly was meant by outsourcing. Elizabeth Buckley, Director of Arete Research, an independent equity research organisation pointed to several possible models for outsourcing, ranging from total Business Process Outsourcing (BPO) at one end to more limited IT infrastructure or applications outsourcing at the other. Yet the cebr data presented on the day did not analyse the findings by type or size of outsourcing deal, prompting FSN's concerns that the findings could be skewed by a very big contract or by a particular mode of outsourcing.

Mark Pragnell, Managing Director of cebr, speaking to FSN after the event conceded that the analysis is "indicative" and it is "impossible to demonstrate conclusively a direct link between share price and outsourcing arrangements - "there isn't enough data," he said though he insisted that the methodology for the study was "robust" and "excluded the possibility of distortion by outsource type or contract size."

Nick Jarman, head of financial management at Atos Origin commenting on the findings to FSN said, "It is an unusual way of presenting the value of outsourcing contracts and I'm not aware of any other research that has been conducted following this line of argument. I find it difficult to believe that outsourcing a small element of a business could influence share price. In addition, if you consider all of the variables that go into value based management it seems strange to pick on just one and say that it affects the share price."

"One shouldn't lose sight of the fact that the success of outsourcing is about execution and not value. If you do it badly the business can be destroyed," he added.

Notwithstanding the possible contentiousness of the report's conclusions, common sense dictates that if outsourcing leads to substantial cost savings, which are often the primary motivation for outsourcing contracts, then this should show up somewhere as improved margins and better cash flows. This in turn should, as Guy Warren, LogicaCMG's UK Chief Executive pointed out, lead to the higher present value of future cash flows and hence stock price. Furthermore, if outsourcing yielded savings that were re-invested in the business this should generate additional returns which, presently, LogicaCMG considers to be hidden.

The problem is that it is virtually impossible to extricate improved financial performance relative to outsourcing from other relevant factors. It could simply be the case that companies that outsource their operations also outperform their peers in the sector because they have good management teams, or tight budgetary control or effective risk management.

To their credit, CMGLogica tried to engage with equity analysts and fund managers at the commencement of their study to determine whether the analyst community factored in outsourcing deals into their share valuation models and what assumptions they made. Kirk Smith, an outsourcing strategist at LogicaCMG, told FSN, "We asked institutions whether it was a reasonable proposition to factor in the effect of outsourcing on share prices but none of the people we spoke to wanted to share their valuation model." There was a clear suggestion that the fund management industry may still be feeling its way in this area as well.

According to Arete, the UK IT outsourcing market is set to grow 7% per annum until 2010 and the BPO market by 10% per annum, versus a projected 4% growth for IT services more generally. Furthermore, it predicts outsourcing in virtually every sector and all business functions. So it is rather disconcerting that there is no effective and agreed means of measuring its impact on share value and the broader economy. This lack of measurement and recognition partly fuels the conclusions in the second part of LogicaCMG's report which says that if the contribution of outsourcing was properly communicated by boards and recognised by the market then considerable additional stock market valuations could be unleashed. However, the paucity of data meant that Mark Pragnell could not confirm for FSN how much of this apparent premium is already priced into current share values - if at all.

If outsourcing is truly of strategic concern then LogicaCMG's report may have unwittingly done the outsourcing industry a service. Inevitably, large scale outsourcing arrangements are relevant to shareholders and so public companies will be required to consider their strategic impact when preparing their Operating and Financial Review (OFR). In addition they may wish to report KPIs governing their contribution to the business overall. The usual metrics used in service level agreements, for example, percentage processing downtime are unlikely to be helpful to shareholders in assessing the strategic value of a 10 year outsourcing deal. Isobel Sharp, a national audit technical partner at Deloitte agrees that outsourcing could be relevant to the OFR. She told FSN, "It really depends on the circumstances but if was major outsourcing arrangement and carried significant risks then boards may consider it relevant and in the interests of shareholders to disclose matters in the OFR."

So inadvertently, the LogicaCMG report may represent a wake-up call to the outsourcing industry and its customers. The industry has to invest in more thorough research which demonstrates the link between corporate performance and outsourcing. The conclusions of "Outsourcing for Corporate Value" may be contentious but they are thought provoking and in the context of the OFR the study is a timely and interesting first step.

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