Tuesday, May 13, 2008

HP + EDS Software: Hey, It's Insinking!

When you think about the HP EDS acquisition, don’t just think about its short-term effect on revenues. Think about the leverage this gives HP to do some long-term software investment -- for excellent profit improvements.

Why am I focusing on software? After all, in a quick scan of press releases and articles on HP’s announcement of its proposed acquisition of EDS, I find little if any mention of the acquisition’s effect on HP software. That’s scarcely surprising: by some calculations software is still less than 4% of HP’s revenues pre-EDS, although the software business is growing briskly. And that will still be true post-EDS. In fact, if you treat their software and hardware revenues and profits as part of one big pot, there’s some basis for saying that the key differences between IBM and HP post-acquisition go something like this:

HP + EDS revenues = IBM revenues – IBM business consulting revenues + HP PC/printer revenues

HP + EDS profits = IBM profits – (HP lower PC margins)

But I think there’s more to the software angle than that. Let me explain.

Way back when I was at Yankee Group, I was so tired of hearing about the glories of outsourcing that I wrote a spoof called “Insinking: The Future Lies Ahead.” The idea was that, since outsourcing was the use of outside companies to carry out an enterprise’s tasks, insinking was the consumption of a company’s products by the company itself. (The source in outsourcing is outside the firm, the sink or consumer in insinking is inside, get it?) Naturally, this lent itself to all sorts of mock-predictions (sample: “Competition will become cutthroat. The resulting bloodbath will leave the competitors red and sticky-looking”).

Well, what was farce now looks like reality. In particular, IBM has now created a structure where software and hardware to some extent compete for the services group’s business against other inside and outside vendors. And the result is, by and large, beneficial; the services group provides an addition to the software/hardware market, while outside competition continues to force long-run improvements in IBM software/hardware’s competitiveness.

To put it another way, as a Sloan Management Review article a while ago noted, there has been a long-run tendency, in high tech companies as elsewhere, to move from vertical integration to autonomous business functions that are more often parts of different companies. Insinking, or whatever you want to call it, says that if the function is autonomous and competitive, it may actually be better to include it in the company, as the cost advantages within the company of the in-house function lead more business for the function, which in turn leads to economies of scale, which leads to greater competitiveness outside the company.

Spoiler note: let’s not take this idea too far. The reason insinking lent itself to farce was that the logical endpoint of insinking’s logic is the consumption of all of a company’s products by the company itself. Such a company would operate at a perpetual loss. It’s a bit like saying that, because reducing taxes a little may actually increase government tax revenues in the long run, we should reduce taxes to zero.

How does this relate to HP software? Well, in the short run, probably very little. HP doesn’t have nearly enough infrastructure or app software to supply EDS’ needs. Insinking may very well be good for HP hardware; but it will, in the short run, not make much of a dent in the relative size of software revenues in HP.

In the long run, however, HP has an opportunity – if it wants to seize it. Insinking for HP software would definitely add software revenues. Since software is well-known for improving profit margins versus hardware and services, any additional software that HP acquires for its software arm will probably be worth more because of its additional sales to EDS in-house and its positive margin effect. So by focusing on growing software’s share of the business, HP would have an unusually strong and good effect on revenues and profits.

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