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Working it out: Stock-market players detect and reward smart outsourcing

Last year, some 28 percent of corporate managers surveyed told Evans Data, a market research firm, that their primary driver for outsourcing was cost cutting. You'd think saving money would catch the eye of Wall Street but, in fact, it doesn't. Researchers Haluk Demirkan, Michael Goul and Robert St. Louis from the W. P. Carey School of Business examined the effect outsourcing announcements had on firm value as measured by abnormal stock returns; they found that only truly innovative contracts made investors take notice and applaud the decision with market buy-in that elevates stock value.

2006-10-25

Last year, some 28 percent of corporate managers surveyed told Evans Data, a market research firm, that their primary driver for outsourcing was cost cutting. You'd think saving money would catch the eye of Wall Street but, in fact, it doesn't. Researchers from the W. P. Carey School of Business examined the effect outsourcing announcements had on firm value as measured by abnormal stock returns. Managers do send work to other firms in an effort to shave costs, gain skill sets, build competitiveness and, ultimately, boost earnings. However, not all outsourcing announcements raise stock prices. Only truly innovative contracts made investors take notice and applaud the decision with market buy-in that elevates stock value. Blue chip special There are many different flavors of outsourcing and many types of people affected by it. Generically, the term refers to transferring work, manufacturing or processes to an outside company. Sending the work overseas is "offshoring." Sending it to a neighboring town, state or even an adjacent country often is called "nearsourcing." As for the people involved, Robert St. Louis, an information systems professor at the W. P. Carey School, likes to borrow categories from writer Thomas Friedman, author of The World is Flat. As St. Louis explains it, Friedman placed people such as top-tier professional athletes in a category of their own; "special" people like them enjoy considerable job security. After all, you can't outsource a Michael Jordan. There are "anchored" people, too. For example, electricians and plumbers need to be near the work to perform it. A plumber from India won't fly to the U.S. to unclog your drain, St. Louis notes. And, there are adaptable people, who change job skills as the needs of the position evolve. Their jobs could be outsourced, but they're able to transition into another position. "Then, there are specialized people with specialized knowledge," St. Louis says, citing surgeons as an example. Acquiring surgical skills takes time, talent and effort, hence, St. Louis likens this kind of specialized knowledge to "asset specificity" in corporations. Specific assets can be either human capital or physical capital, he continues. For instance, drilling equipment for an oil company is asset-specific to an industry. It has value at an oil well but wouldn't be useful in, say, a china shop. "Asset specificity could also be a kind of product differentiation, something you might get a patent on," says IT professor Michael Goul, one of St. Louis' colleagues at the W. P. Carey School. In addition, specific assets might be processes or systems. Haluk Demirkan, a third W. P. Carey information systems professor involved in outsourcing research, uses a credit-card company to demonstrate this point. "They may have processes for several areas: human resources management, procurement, credit-card processing," he says. Human resources and procurement are functions that could be similar in various firms so, in a way, they're standardized and commoditized. But credit-card processing? That's specialized, something a credit-card company should do quite well. "A credit-card company may outsource their HR management or procurement, but they'll probably keep their core business in house. If the HR system doesn't work, it won't take the company down. If the credit-card system doesn't work, the company will go out of business," Demirkan says. It is precisely this kind of risk that has prevented companies from outsourcing asset-specific knowledge, people, processes or manufacturing in the past. "People thought that if you outsourced asset-specific activities, it would be dangerous for your company and hurt your stock prices," St. Louis says. Yet, when St. Louis, Goul, and Demirkan joined with Mark Avery Gill, an IT professor at the University of Louisville, in researching the subject, it was clear that market perceptions had changed. Now, the arrangements that raise corporate value are those that announce the outsourcing of asset-specific activity. Many happy returns Demirkan et al. used the event-study method to evaluate a large number of outsourcing contracts. Such studies look at stock market activity within a small window of time surrounding an event, which was an outsourcing announcement in this case. The team evaluated announcements along several lines. Did market participants favor offshoring contracts over domestic agreements? Offshore contracts have more risks. They're harder to manage, but they still delivered an abnormal return that was 3.02 percent higher than normal returns used for comparison. "Conversely, the market had a neutral reaction when the announcement was for a domestic IT outsourcing contract," the researchers note in a recent paper. "This indicates that investors find the greatest potential for future earnings coming from firms that include offshore outsourcing as part of their technology strategy." Contract size came under investigation, too, and the team evaluated it relative to the size of the company. In this case, size didn't matter -- much -- unless it was a big contract going to an offshore company. Then, abnormal returns rose 4.98 percent. A similar finding occurred in looking at repeated outsourcing. Domestic contract announcements upped returns 3.14 percent, while offshore contracts raised that level to 4.11 percent. The big eye-opener, however, was in asset-specific offshore contracting. That combination generated returns that were 5.42 percent above normal. "Our major finding is that the market is solid when something is outsourced that may be highly asset-specific," Goul says. Understanding business processes and knowing how to commoditize them so that they can be outsourced is what gets firms recognized, St. Louis says. "If you simply outsource something that everyone already recognizes as a commodity, there's no reason for you to be rewarded. But, if you're the first to recognize a piece that wasn't commoditized before and can be, you get a market reward." Large contract and fries "A few years back, if someone had told me that accounting functions in the United States would be outsourced to India, I wouldn't have believed it," says Demirkan. "Now, I know a lot of accounting firms, including my own accountant, that send the data entry for tax forms to India." In fact, remote staff can handle many positions that previously looked like anchored jobs. Quoting Friedman again, drive-thru order-takers at McDonald's, for example, may be sitting in another time zone when they ask if you want fries and a coke with your burger. Franchisees have reported fewer errors and faster service when order-takers are sitting in a call center, far from the frenzy of food preparation in the restaurant kitchen. According to Goul, the research team's findings indicate that when novel things are outsourced, stock market participants may be interpreting the innovation as a breakthrough discovery on how to turn asset-specific items into something that's now commodity-class. Or, investors may interpret the action as a corporate grab for top-tier sources. Either way, inventive outsourcing makes the market respond favorably, Goul says. On flip side, some outsourcing is expected," he notes. That's why sometimes it hardly raises an eyebrow -- or stock value -- among investors. Jack be nimble St. Louis maintains there are many activities that previously were considered asset-specific but, in fact, were merely anchored. Order-taking at a McDonald's drive-thru and data-entry on tax accounting are two such activities. Airplane design at The Boeing Company is another. It's not limited to Seattle anymore. Now, engineers in Russia contribute, as well. "If you talk to Boeing today, they'll say that they're not a manufacturer," St. Louis says, adding that company leaders now see their organization as a "system integrator." Standardization -- which allows for easier integration of components -- is one reason outsourcing has become popular in the last decade. The widespread adoption of the Internet and the proliferation of fiber-optic cable that facilitates high transmission speeds for data also come into play. With progress comes change and, last February, analysts at the consultancy Deloitte Touche Tohmatsu predicted that 2006 would be the year that "offshoring evolves from option to obligation." Today, more than 77 percent of companies with more than 1,000 employees engage in some form of outsourcing relationships. What does the mean for information-technology professionals? Well, it's probably not cause for hand wringing. Studies show that outsourcing doesn't increase U.S. unemployment figures. Jobs don't disappear. They change. "When outsourcing first started, a lot of software development went to India," Demirkan says. That means U.S. companies don't need many developers anymore, he adds. "But, we will need more people who have project management and integration skills." Skill sets aren't the only thing changing for IT workers. "When business managers design architecture for enterprise information systems, they need to keep agility and flexibility in mind," Goul says. "If they design structures that are too rigid, it will constrain their ability to take advantage of opportunities." Monolithic enterprise packages may not be the right choice anymore, he continues. "Do you use every function in your word processor?" Goul asks. His point: open architectures, not huge, single-source enterprise systems may be something to consider. They're more adaptable to inter-company collaboration. According to the W. P. Carey School researchers, the trend toward outsourcing means companies face enormous choices and opportunities, not merely in the systems they use, but also in the people they hire. "Through globalization, you're getting best-of-breed capability and people who can produce something you wouldn't be able to produce in-house," Goul says. And, it seems that investors are remarkably savvy in "sorting out when managers are making outsourcing decisions that will give them an advantage for some period of time," St. Louis concludes. "We were surprised by how shrewd market players are in recognizing when companies outsource something that people didn't think could be outsourced." Bottom Line

• Companies may go into outsourcing for a number of reasons: cost-savings, skill-set acquisition, speed to market and more. All are designed to create competitive advantage.
• Not all outsourcing announcements generate a positive market reaction as measured by stock values.
• Innovative outsourcing contracts, where firms send out what was previously considered an "asset-specific" business process, trigger the greatest amount of abnormally high stock returns.
• Many outsourcing contracts create no discernable reaction among investors, indicating that the market expects companies to engage in outsourcing.
• The proliferation of outsourcing is changing the skills IT professionals will need. Demand for project management and integration know-how is likely to rise.

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