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Unlocking the value in your IS department.

Unlocking the value in your IS department

Is there some hidden value in your information systems department? By asking just a few "test" questions, you'll avoid overlooking a moneymaker for your firm. Here's a guide to get you started. Senior managers of many corporations are searching for creative ways to increase the value of their companies. And many are finding hidden value in a surprising location--the information systems (IS) department.

Companies are finding that it is possible to increase their market value by an amount equal to one to two times their annual IS budget, or even more. Some are accomplishing this by leveraging their IS assets into new businesses, others by moving their IS organizations to new levels of productivity. But either strategy raises serious management issues.

Restructuring--macro and micro

American industry has been restructuring--recapitalizing, merging, acquiring, divesting--in order to increase the value of an enterprise to its owners. While some individual transactions have been controversial, the overall trend--to uncover and unlock undervalued corporate assets--has undoubtedly been beneficial.

The primary thrust of this restructuring has been to translate the value of an internal business operation to the enterprise into its value in the marketplace.

A common mode of restructuring has been the conversion of an embedded business operation (typically, a division) into a more or less stand-alone business. Sometimes, ownership of the new business, or free-standing division, remains with the parent. In other instances, ownership of the new business changes: to parent company stockholders (spin-off); to new owners (sale); or to the managers of the business and related investors (leveraged buyout).

According to the logic behind the restructuring, when the managers of the new business unit have greater control and greater incentives, its profitability can be increased. Furthermore, since the financial markets will now assess the parent and new business separately, the value of the parts may be expected to exceed the value of the whole.

Candidates for successful restructuring typically have the following characteristics:

* They can stand alone; they have well-defined products and/or services, their own markets, and assets distinct from the parents'. * Independence may result in lower costs; their cost structure is driven by factors different from those affecting the parents' cost structure. * They have assets, such as products, that are underutilized and could be exploited more effectively. * They have predictable and stable cash flow. This is important, because restructuring frequently involves the addition of substantial new debt, and cash flow must be sufficient to service the debt.

From this perspective, the IS departments in many large companies are ideal candidates for restructuring.

First, a department's products and services are information support, which has a potential market that includes at least all of the companies in the industry to which the parent belongs, and possibly all companies that use computers and communications.

Second, most IS costs are for people and equipment. Equipment costs are determined by information-industry market forces, not those of the parent company's industry. People costs, for salaries and benefits, would also be determined by information-industry market forces, if companies do not apply to IS the same compensation and personnel practices they apply elsewhere in the company.

Moreover, IS departments are often organized and staffed in accordance with traditional patterns or to meet client expectations rather than strictly to fulfill their mission. For these reasons, costs are typically reduced when the IS department is released from corporate constraints, and its practices, policies, and incentives are changed from those of a cost center or cost distribution center to those of a profit center.

Third, the IS department has frequently developed its own application systems, communication networks, and professional expertise with potential value to external customers. However, to realize their hidden value, these offerings require upgrading to commercial standards and must be professionally marketed.

Finally, the cash flow of an IS department is its revenue from a single customer--the parent corporation. This cash flow very rarely decreases; in fact, it increases anywhere from 5 percent to 20 percent annually.

Indeed, many companies in industries as diverse as agriculture, banking, insurance, manufacturing, and transportation have created IS subsidiaries in order to unlock their hidden value. But these values can also be obtained while keeping IS internal to the corporation.

The in-house advantage

Here are some proven strategies for creating value from IS, without restructuring the department to be a separate business:

Selling IS products--Most large companies have amassed a portfolio of custom-developed application or utility software systems, which costs many millions of dollars to create. (In some cases, although less frequently, they have developed custom equipment as well.) Some of these systems have potential value to other companies, since the business or technical functions the systems support are usually performed in many other companies as well.

When the availability of the product to other companies will not compromise the owner's competitive position, this value may be translated into revenue by selling the software (or hardware) to other companies, either directly or through a marketing intermediary. First, however, the product and its support must be upgraded to commercial standards. When a marketing intermediary is involved, the deals can be structured with some combination of up-front cash and continuing royalty and/or maintenance payments.

Examples of companies using this type of value-creating strategy are:

* An airline selling its maintenance and engineering management system to domestic and international carriers, with full support, and generating revenues of $1 million or more annually. * A railroad selling its crew-calling system. * A petroleum company selling a shipboard inventory management system, wellhead monitoring software, and process control and management systems for terminal operations. These products were distributed both directly and through third parties and generated revenues of about $1 million annually. * A diversified manufacturer selling distribution applications through a software marketing firm in which it eventually took an equity position.

Selling IS services--This concept is not new. In the 1950s and 1960s, when computers were scarce, expensive, and mostly batch oriented, it was common for large companies to sell blocks of unused computer time to other companies. This practice diminished as computers became cheaper and more plentiful, as applications came to rely more upon telecommunications, and as commercial timesharing and remote processing services began taking hold.

Today, there is less opportunity to sell commodity-type services and greater opportunity to sell value-added services that leverage the unique skills and experience, as well as the facilities, of the IS organization: systems and programming, technical support, network services, disaster backup, and so forth. These deals usually have the supplier selling the services directly, sometimes with the aid of a broker.

Many of today's large computer services firms, such as McDonnell Douglas Automation Company and Boeing Computer Services, began as internal IS support organizations.

Other examples of companies parlaying their IS expertise into profits are:

* A transportation company using its own electronic mail system initially to link with customers for electronic data interchange, then to sell EM services, and finally to sell the software. * An agricultural cooperative providing disaster recovery services, facilities management, value-added processing based on customers' software or packages, and resale of voice and data telecommunications. This company generated revenues of about one-fourth its IS budget, with pre-tax margins of approximately 10 percent. * A midwestern utility providing a high-quality remote system development environment and generating annual revenues of $12 to $15 million. * Another transportation company generating revenues equal to one-fourth its IS budget, with pre-tax margins of about 20 percent, by providing turnkey system development and facilities management for claims processing. * A petrochemical company that leveraged its substantial investment in a portfolio of state-of-the-art applications by selling value-added processing of petroleum industry and financial applications. * And hospitals that sell a range of telecommunications services to physicians and patients, such as telephone service, long-distance resale, answering services, paging, voice mail, and video conferencing.

Selling the right to service the corporation--Facilities management firms will enter into long-term contracts with a company to take over its IS operations and continue providing services at 10 percent to 25 percent less than its current costs. The facilities manager is able to do this, and still make a profit, because of its more profit-oriented approach, lower cost structure, and business expertise. While these deals are usually structured to provide the corporation with a discounted expenditure over the period of the contract, the facilities manager will sometimes be willing to make an up-front payment (equal to a portion of the present value of the stream of discounts over the period of the contract) in exchange for a lower discount.

For example, a multibillion-dollar pipeline company that was spending $90 million per year on data processing entered into a 10-year contract with a facility manager to provide the same services for 21 percent less.

Slashing IS costs--Many of the same economies available to the facilities manager are also available to the resturctured IS organization. Companies can use this same strategy (reducing the cost of providing IS services to the corporation) in order to produce comparable value while retaining greater control.

Some of the areas in which IS costs can be cut are equipment purchase and financing policies; rent and space; fringe benefits; corporate general and administrative allocations; and overhead personnel (indirect labor).

Moreover, by converting internal customers to a full-charge basis at prevailing market rates, many companies find that demand patterns change, which allows for the downsizing of staff and sometimes equipment.

For example, one insurance holding company with centralized IS has decentralized its system development activities to the operating companies, cutting data center costs by 10 percent in the first year and by 20 to 25 percent over two years.

Some self-examination

How much value is there in an IS department? While many factors obviously influence its value, typical valuations are one two times its annual budget.

Take, for example, Company A. With earnings equal to 5 percent of revenues, IS expenditures at 2 percent of revenues, and a price/earnings multiple of 10, it has a market value equal to 50 percent of revenues.

If Company A's IS expenditures are cut by 20 percent to 1.8 percent of revenues, then earnings will increase to 5.2 percent of revenues. With the same P/E multiple, the market value of Company A will equal 52 percent of revenues, an increase of 2 percent of revenues, or the value of the annual IS budget.

Then look at Company B. With the same IS budget and P/E multiple as Company A, it begins to sell its IS products and services. Instead of cutting IS expenditures, the company increases them by 25 percent to 2.5 percent of revenues. The IS products and services add 1 percent to corporate revenues, so that earnings increase to 5.5 percent of revenue. With the same P/E, the market value of Company B increases to 55 percent of revenues, an increase equal to twice the annual IS budget. Moreover, if the financial markets value Company B's new information services business more highly than its traditional business, its P/E may increase.

Before a company can unlock the value in its IS department, however, it must confront a range of important issues beyond the value of the IS assets. For instance, how do the services or products the IS department has to offer compare with the needs of the marketplace? Who is the competition? How ready is IS to compete? What are the barriers to market entry?

The company also must consider if it is better off selling its IS assets or retaining and exploiting them itself. Which alternative produces the greatest value? Which alternative represents the least risk? How should a sale or joint venture be structured? How would a company-owned IS business be organized? How well would current IS management and staff do in a profit-oriented organization?

Then how likely is it that the expected values will be realized? What are the forecasted sales and the estimated marketing share(s)? How certain are contractual payments by intermediaries, partners, or facility managers? Are there offsetting costs? What future events could affect values?

And how will this affect the ongoing support of the business? Will support costs be more or less predictable? Will the company have greater or less flexibility to respond to changing business needs? Will the company receive adequate attention and priority from the facility manager or from the management of a profit-oriented IS subsidiary?

These are all clearly essential questions, but they're ones that are very difficult for the IS or other company staff personnel to answer accurately and objectively. That's why every firm must thoroughly examine its own IS department to plot the best route for making that segment of the corporation most profitable.

PHOTO : Animal Locomotion, Plate 672 Eadweard Muybridge, circa 1887, photogravures
COPYRIGHT 1990 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Title Annotation:information systems
Author:Klein, Mark M.
Publication:Financial Executive
Date:May 1, 1990
Previous Article:Information technology - should you curtail your investment?
Next Article:Eastern Europe: tread softly, joint venturer.

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