IT OUTSOURCING

Does IT Outsourcing Benefits Shareholders? Evidence from the Market

Amirsaleh Azadinamin
Swiss Management Center (SMC) University Doctorate Program Candidate

December 19, 2011

Electronic copy available at: http://ssrn.com/abstract=2017420

IT OUTSOURCING Abstract This paper looks upon IT outsourcing of companies and how the process adds value by offering numerous advantages. Numerous factors that are mentioned and discussed include the cost saving, transferring responsibilities to those with more expertise, and gaining more focus and flexibility by abdicating non-strategic operations that helps companies gain more efficiency, improve quality, and focus more on core competencies. The proposition of added value by outsourcing IT has been supported by both empirical evidence and common sense, and thus, managers must take steps to review internal IT activities and seek candidates for outsourcing. The empirical evidence is shown by monitoring the share prices of the given companies over a

certain time period starting 40 days prior to the public press release on outsourcing until 40 days after. The evidence shows that this group of companies outperforms the market in the same period by almost 6% over the 80-day period.

Electronic copy available at: http://ssrn.com/abstract=2017420

IT OUTSOURCING Outsourcing Non-strategic Processes Increasing competition, rapid technological changes, global integration of markets, deregulation, and privatization have pushed many organizations to outsource their non-strategic

processes in order to focus on their core business expertise by abdicating responsibilities that the company possesses less expertise. Cox et al., (2011) states, [t]he use of outsourcing, although not a new phenomenon, has increased in recent years as firms seek to lower costs and increase efficiency in response to higher levels of global competition (p. 141). Outsourcing has become a significant issue in reforming of organizations and many commentators agree that it is currently one of the fastest growing and most important activities in business (Cox et al., 2011). The outsourcing process has caused managers to realize the benefits of outsourcing by gaining more focus and specialization in their core competencies. IT industry has been at the heart of this outsourcing trend. IT outsourcing has been one of the major fields outsourced in the process of non-strategic outsourcing that enables managers to better focus on their vital field linked to the core of their strategic path. Qu et al., (2011) state that the benefits of IT outsourcing for firms have been well documented in the literature, and it suggests that IT outsourcing can provide firms with various economic, technological, and strategic benefits, such as reducing IT operation cost, improving technical competence, and even providing competitive advantage. Qu et al., (2011) continue, [v]arious factors play an important role in determining IT outsourcing utilization, including business and IT cost structures, internal IT competence, transaction costs, knowledge gained from IT vendors, cost advantages of IT vendors, and spatial distance (p. 100). The process causes these companies to lower their cost while gaining more expertise by transferring the responsibility to those with higher expertise in the concerned field, while gaining more profit by better focusing on fields vital to their business. Glassman (2000) also mentions

IT OUTSOURCING that information technology has been the most popular area in outsourcing and that according to IDC, IT outsourcing transactions accounted for about 20$ billion, or 40% of US outsourcing

activity in 1998 (p. 1). The fast pace of change in the field of technology also causes companies with IT as their non-strategic field to fall behind those who outsource IT, as it is surely unlikely for a company to obtain or possess expertise in all fields. Cox et al., (2011) further state that IT outsourcing will [also] allow firms to pass the risk of upgrading technology to their provider and allow them to respond more quickly to changing needs and prevents them from getting locked into technology (p. 196). Impact on Share Prices Many researchers have studied the effects of the outsourcing process on businesses and how share prices are influenced by the process. As it was mentioned, IT has been at the heart of outsourcing trend, and as Domberger et al., (2000) mention, among the most frequently IT services outsourced is IT maintenance and support, and yet, outsourcing contracts are more likely to focus on specific IT functions data centre management, applications development, maintenance and support, systems integration and project management (p. 108). One may ask whether outsourcing non-strategic processes, which could be viewed as a distraction to the business, or will they add value to the company? Some may argue that outsourcing would add value if it originates more focus on core competencies in return. One may also wonder whether the process will be reflected in share prices. To answer this question, Stern Stewart & Company performed a study to determine whether companies that outsource information technology receive a boost from the market when this strategy becomes known (Glassman, 2000, p. 2). Stern Stewart & Company based their research on 27 mega-deals

IT OUTSOURCING from various countries like the UK, France, Japan, South Africa, and New Zealand, and conducted their study on how this change will influence share prices. It is essential to explain the trend of change in share prices regarding a particular time frame. The price change that is resulted from outsourcing will not be instantly reflected in share prices; rather it will take effect over a period of time. On the other hand, the news does not have to be officially announced in order to see changes in price. The news will be reflected on prices long before they are officially announced by the company, or what is referred to as time zero. The price change is observed many days before time zero, as the rumor of outsourcing gets out, or when the news is announced solely to the employees before the public press release. The public press release is denoted as day 0. The same trend is plotted on a graph, shown in Figure 1 (Glassman, 200, p. 2), against the S&P500 index for better illumination and comparison. As shown in Figure 1, there is evidence of positive impact on stock prices from IT outsourcing. The graph concerning the impact of IT outsourcing is aggregated from all 27 companies to determine the overall returns from outsourcing.

IT OUTSOURCING

Figure 1. The impact of IT outsourcing on stock prices. This figure compares changes in share prices of group companies with S&P500 index. (Reference)

As depicted in Figure 1, the group consisting of 27 companies with the common characteristic of IT outsourcing have outperformed the market by 5.7%. Glassman (2000) further explains, for a company with equity capitalization of $7 billion (the median for an outsourcing group) the average increase in value is $400 million. Considering the median contract size of $1 billion, these benefits are substantial (p. 2). It is also evident from the graph that the time period considered for the research starts 40 days before the public press release, and goes on till 40 days after. It is also worth mentioning that the graph is the aggregated graph for all 27 companies, as it was mentioned, and not all individual companies reacted in the same manner. The price changes of three companies were considered about break-even, with a price fluctuation of less than 1%. After analyzing the gain over the given time period, Glassman (2000) mentions some facts about the trend:

IT OUTSOURCING It is interesting to note that the excess stock returns begin prior to Day 0. By Day -20, approximately one month before the press release, the average company had returns of 1.1% over the market. By Day -1 the excess returns had reached 2%. A likely explanation is that to facilitate the transition to the new service provider, company employees are informed of the initiative about one month before the public announcement. This information quickly filters into the general market. Continuing to trace the pattern of returns, another 1% gain accrues to the outsourcing group on the day of press release, when this information is confirmed. By day +20, the excess return accumulates to 5.6%. While we extend the data for another month (20 trading days) the excess return remains about the same. In other words, the entire return is reflected in the stock price by the end of the first month following the public announcement (p. 3).

When this study is extended to a longer track period and monitoring, observations differ, even though the results are somewhat the same. This leads the discussion into the next topic. Tracking Stock Returns from Six Months Prior To Announcement Positive returns are bigger when the track period is longer. Stern Stewart & Company (2000) realized this phenomenon when the study was done looking at a six months period prior to the public press release. Glassman (2000) continues that, for a period six months to two months prior to the announcement, the group accumulated excess returns of 5.1%, and 7% up to day -1. Furthermore, [b]y day +20, the excess returns grow to 9.7% without significant growth thereafter (p. 4). In this case, where the period of study was six months, the total excess return at Day +40 was 9.9%. Regardless of the time frame considered in the study, the majority of the increase in stock prices occurs before the public press release, meaning the information has already been reflected on stock prices before the public announcement; however, one may ask

IT OUTSOURCING why the increase is larger in a longer time period. Glassman (2000) believes one explanation may be that for a sizable company such as those considered for the study, the due diligence is

underway as much as six months before the outsourcing transaction. After the due diligence is initiated, the speculation about outsourcing is filtered into the market, and hence, stock prices start to rise. It is only sound that the due diligence process, which is potentially a significant event for the company, filters out into the market and draws reactions from investors. Due diligence in the outsourcing process is the study of client and their responsibilities and capabilities for the company in accepting the job, along with the potential profits for the company in outsourcing the field. There is one important caveat about the methodology. The number of companies contained in the sample is not very large, making the results less than statistically conclusive.Still, that only 7 out of 27 deals were negative provides strong affirmation of the positive view of outsourcing in the market place (Glassman, 2000, p. 4). Cha et al., (2009) offer numerous reasons on why companies may profit from this outsourcing process. Some of these factors include lower production costs of outsourcing vendors due to their superior production economies and technical expertise; a firms need to focus on its core competencies rather than to be distracted by the outsourced field; firm-level characteristics such as financial characteristics, firm demographics and strategic focus; and ITlevel characteristics. Concluding Remarks Glassman (2000) suggests that IT outsourcing helps companies add value by offering numerous advantages. It is the cost saving, transferring responsibilities to those with more expertise, and gaining more focus and flexibility by abdicating non-strategic operations that helps companies gain more efficiency, improve quality, and focus more on core competencies.

IT OUTSOURCING The proposition of added value by outsourcing IT has been supported by both empirical evidence and common sense, and thus, managers must take steps to review internal IT activities and seek candidates for outsourcing (Glassman, 2000). There is however one question that Glassman (2000) has failed to answer, and it could extend the research to a greater length. The question is: has the rise in stock prices been due to market optimism on outsourcing, or has it been due to the actual operational efficiency after outsourcing? Because even Glassman (2000) mentions that the process receives attention of the market in term of share prices when this strategy becomes known (p. 2). Surely, the outsourcing has not had any effects on operational efficiency before the actual outsourcing happens, and yet the share prices rise; thus, the rise in share prices is not the result of operational efficiency. This matter could only be furthered looked into if the track period considered for price monitoring was extended to a longer period after Day 0. Glassman (2000) has also failed to mention whether 40 days is the right number for days of monitoring after outsourcing occurs. The research done by Glassman (2000) focuses only on price changes, but fails to offer reasons behind it. Does the previous gain in stock prices sustain if the monitoring period extends to a greater length? Facing this question and lacking a concrete answer in this paper, one might believe that the increase in stock prices may be due to a complete market fallacy that outsourcing increases operational efficiency, as one knows of various market fallacies, and as also Brown (1949) warns his audience: IT IS HIGHLY IMPORTANT in the teaching of economics that students be taught to analyze various widely held fallacies and that they learn how to refute them convincingly. Any teaching which leaves them the easy victims of such (often) plausible

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fallacies is to that extent inadequate and superficial. Any such teaching is not lessbut, rather, all the moreimportant when some of the fallacies have had the support not only of many of the politically "great" but of well-known professional economists! (p. 177). In light of this inarguable fact, one may ask for numeric evidence based on financial statements of the business in order to prove IT outsourcing does add efficiency to the business, as one may also provide the counter argument that outsourcing also causes the business to face the further risk of properly nurturing the contracting company who has taken the outsourced job. Cox et al., (2011) also mention that another risk that the business faces is in regards of the term and duration of the contract, and states, longer contracts will be required to allow the provider to recoup their investment costs although longer agreements could contain greater risks in terms of over-dependence and inflexibility (p. 196). These are some of the factors overlooked in the research done by Glassman (2000), and answering these questions will surely take the discussion to a greater length. Thus, one may reason that the increase in stock prices is more of a positive outlook on the company due to outsourcing than the actual increase in operational efficiency.

IT OUTSOURCING References Cha, H. S., Pingry, D. E., & Thatcher, M. E. (2009). A learning model of information technology outsourcing: Normative implications. Journal Of Management Information Systems, 26(2), 147-176.

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Cox, M., Roberts, M., & Walton, J. (2011). Motivations for IT outsourcing in public sector local government. Proceedings Of The European Conference On Information Management & Evaluation, 141-149. Domberger, S., Fernandez, P., & Fiebig, D. (2000). Modelling the price, performance and contract characteristics of IT outsourcing. Journal Of Information Technology (Routledge, Ltd.), 15(2), 107-118. doi:10.1080/026839600344302 Glassman, D. (2000). IT outsourcing and shareholder value. EVAluation, 2(5), 1-8. Gunnison Brown, H. (1949). Economic fallacies and economic teaching. American Journal Of Economics & Sociology, 8(2), 177-180. Qu, W., Pinsonneault, A., & Oh, W. (2011). Influence of industry characteristics on information technology outsourcing. Journal Of Management Information Systems, 27(4), 99-128.