Taking Stock: Downturn Hits IT Services Hard

The pain of downsizing is likely to continue as sales remain weak
Even after March 24's market tumble, when investors became aware that war rarely goes as predicted, the Goldman Sachs technology index was still up 3.2% so far this year. The best-performing segment was Internet-related companies, up 16.9% year to date; the laggard was services, down 9.8% for the same period.

People still trade at eBay and buy at, even in anxious times like these. But Goldman Sachs' networking, semiconductor, and hardware segments were no slouches either, up 9.7%, 8.2%, and 7.0%, respectively. Software was flat for the year. This month has brought news from Oracle of a difficult earnings outlook and warnings of weak results ahead from some other software companies, so that should come as no surprise.

The difficult question is why the IT-services segment, usually stable, is doing so badly. We could point to EDS, with its multitude of maladies, but that would be too easy. Aside from infrastructure outsourcing, which favors large companies such as Accenture and IBM, the outlook for IT-services spending is pretty bleak. In this environment, cheaper offshore consulting services are gaining ground and making pricing difficult for domestic IT-services vendors. Even though government IT spending, especially federal spending, should hold up in the near term, not much else will. This will benefit companies such as Computer Sciences Corp., which earns more than 40% of its revenue from federal IT spending but not many others. Second-tier players such as Perot Systems and BearingPoint come to mind. They're not bad companies, but as IT spending shrinks, they may lose more than their fair share.

Some of these companies don't help themselves in a tough spending environment. Investors hate uncertainty, and uncertainty increases with changes in senior management. Nevertheless, sometimes it makes sense for a company to bite the bullet and replace senior management. The most recent notable hit was at EDS as Michael Jordan, formerly of CBS, took over as CEO for Richard Brown. Investors liked that move, as the stock price rose on a big down day in the market. But EDS shareholders can't have been happy that the company had to pay $37 million to the exiting CEO to clean up this mess. It's a shame that for two year's worth of work, Brown will get almost $19.6 million in pension benefits alone. I bet there are a lot of laid-off workers who would like any kind of pension benefit after such a short time. Is it any wonder that EDS hangs under a cloud these days?

Another big change was the new CFO at BearingPoint (formerly KPMG Consulting), Robert Falcone, a former CFO at Nike. Only time will tell whether these changes will be beneficial to the companies and shareholders.

The U.S. technology sector lost about 560,000 jobs during 2001 and 2002, according to the American Electronics Association. That's about a 10% reduction in head count to about 5.15 million technology jobs over the last two years. Most of this was in manufacturing and communications, but it crossed all sectors. The pain of downsizing is likely to continue, as sales remain weak. I just wish a few of the mainstream IT folks could get some of EDS's Brown's generous retirement package. But I won't hold my breath.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected].