KUHN CAPITAL Wednesday, March 21, 2018
Dispatches from the front

Where Does Offshoring End?

The September 29th Forbes featured an article entitled “Giant Sucking Sound” about how EDS is firing thousands of US and European employees and hiring in their place workers based in India, Malaysia, Hungary and Mexico. While among the largest tech services vendors, EDS has also been among the slowest to react, but the company’s recent red-inked financial performance now has management’s full attention.

The phenomenon of substituting cheap, educated offshore workers for their high-priced American and European counterparts is not restricted just to software coding and other IT services. The offshore tide is sweeping before it a myriad of other industries, some of which may seem surprising. For instance, in additional to all manner of inbound and outbound call centers, we now see small but growing Indian market research shops selling multi-clients studies and equities research, and in many cases providing the underlying data for high-priced consulting reports like those generated by McKinsey. A friend of ours even envisions phone banks of offshored legal advisors trained in routine American divorce, bankruptcy, and small claims proceedings. In fact -- given the irreversible progress of ever cheaper and faster digital communications -- the only boundaries to offshoring seem to be our imagination.

Offshoring, the Killer App
Offshoring is a subset of outsourcing, or the moving of large company functions to an outside vendor. The original advantages of outsourcing were merely the saving generated by lower overhead structures, and by the efficiencies of the outsourcer’s laser-like focus and expertise on the task at hand. Early examples of outsourcing: temporary clerical and janitorial help, third-party administration of health benefits (TPA’s), call centers, project-based workforces supplied by professional employer organizations (PEO’s), and logistics services.

From there, outsourcing spread into marketing services, perhaps most spectacularly into software development and computer systems maintenance, among doctors and nurses, and now even into the supply of “C-level” executives like CFO’s and CIO’s. Another example is in the supply of HR IT processes: big contracts in this field have rocketed from about $1B in 1998 to an estimated $4.2B in 2003. As outsourcing has rippled through American industry, it has supplied the LBO and later-stage venture capital community with rich investment opportunities.

But now we’ve reached another, seemingly inevitable, stage: the outsourcing of talent to foreign shores, or offshoring. Whereas earlier outsourcing economies were generated by increased local efficiencies, now the huge wage differential between American and European workers versus third-world employees has thrown gasoline on the outsourcing fire. It’s the difference between $10 and $1.25 per hour. And it's why Indian exports of software and services rose 26% to nearly $10B last year.

With our focus on IT M&A, we see these changes expressed in quite specific ways: increasing numbers of the buyers we encounter are money-making Indian outsourcers, while increasing numbers of the sellers are money-losing American tech services vendors. These American companies are being purchased mostly for their clients: typically, post-purchase, the target's tech services staff are terminated in favor of overseas replacements.

First Response
The American political class is gradually awakening to the cries of pain among its constituency and is predictably responding with regulation or the threat of it. On the Federal level, they’ve tightened the number of work visas issued to foreign nationals, though of course this won’t deter the provision of expertise via phone or data line. And New Jersey and Wisconsin are pressing local companies that perform various government transaction processing services to keep jobs local. Expect to see a lot more bluster and rhetoric on this topic.

But in our opinion job protection legislation will prove ineffective, if not wrong-headed. How can government monitor whether a company is using an offshore data service, and if it could, should it prohibit an activity that may be necessary for the company to survive? What about the rights of the consumer or taxpayer to purchase the cheapest solution? The issue is NAFTA writ large.

Therefore assuming that continued offshoring is inevitable, the question becomes, where is it leading us? Technology has forever made the market for brains and expertise global. After exporting its manufacturing sector overseas, now America is seeing its great growth engine – the services economy – under the gun.

Safety Zones
The threat is not universal. Certain industries like retailing and just-in-time or rapid manufacture-to-order will remain safe, as will services that require “feet on the ground” like claims adjusters or home services vendors. Even within industries that are subject to offshoring, like IT services, we see functions that are, at least for now, less vulnerable. They have to do with high-level marketing and sales contact, and with the provision of various specialized, strategically-critical expertises. For instance, IT consulting services that understand business processes or how to make their client’s IT a strategic weapon will survive, albeit with an offshored “backend”. Another type of activity that provides refuge is in the creation of novel solutions, even new industries, based on a superior understanding of end-user needs. See Clayton Christensen’s writings on this subject for more detail. In a word, getting ever-closer to the end-user with services specialization and creativity may be keys to the future.

Having said this, we’re braced for widespread migration of American jobs overseas. Maybe it’s time for the politicians to get serious about the global uncompetitiveness of American education.

Ryan Kuhn

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