Market Revolution

VARBusiness

Realizing that the plates are shifting from under us--that many of the business models that made sense just three years ago are no longer competitive--VARBusiness decided to add an important compare-and-contrast component to this year's State of the Market study. In addition to reporting our comprehensive survey documenting industry progress, trends and pain points, we thought it would be useful--and significant--to measure the degrees to which the industry has changed essential business models over two- and three-year increments. Use our findings as a learning tool to measure your company's strategies to the market's evolution, then perhaps evolve in response.

Change is something Jaime Gmach, president and CEO of Minneapolis-based Evolving Solutions, knows about firsthand. When he started his reselling business in 1996, he had no idea what it would become over the years, though he knew he had to remain flexible to keep ahead of the number of competitive start-ups in the region (hence the company name).

"We knew that where we started out was not where we would end [up]. We knew the company would change into something totally different based on the strategic plan we laid out," Gmach says. "We've achieved our business vision pretty successfully [moving] from hardware to helping customers solve business problems. The difference between what we were doing in '96 and today is light-years apart."

Starting out as a reseller of used and recertified IBM equipment, Gmach grew quickly, from only three employees and $3 million in hardware sales during his first year, to a projected $58 million in sales this year with 46 employees. How did Gmach do this? By distinguishing his company with virtualization technology.

"We made a commitment to virtualization once we were confident it would help our customers solve business strategies," Gmach explains. "We probably invest 25 percent of our R&D costs in the technology, exclusive of personnel, customization and scripting."

Asked how the business has changed for him since he opened his doors, Gmach couldn't stop laughing--ruefully.

"In '96, there was room for error. If something didn't work, it wasn't necessarily catastrophic," he says. "Today, if you are not executing more efficiently than the guy next to you, or are not assessing very deeply the risk you are taking, you're in error. And there's no tolerance for it. And in our business, we need to take risk."

How Do You Make Money?
What's your profile as 2005 approaches? How do you want the industry to see you? Shockingly, the desire to be called a total-solution VAR, once thought to be a surefire way to gain access to valuable enterprise accounts, appears to be on the wane, according to the results of our proprietary 2005 and 2002 State of the Market studies. For example, almost half (49 percent) of large VARs (which we define as having more than $10 million in annual revenue) surveyed three years ago defined themselves as total-solution VARs. Our new numbers indicate that only 28 percent now do--more than a 40 percent dropoff. Similar patterns exist among small and midsize VARs.

Conversely, the notion of calling your business a consultancy is on the rise. Fully 38 percent of all small VARs (with less than $1 million in annual revenue) that were surveyed said their company's primary business activity was consulting. That's up 15 percent from three years ago. Additionally, 23 percent of midsize VARs (with yearly revenue of $1 million and under $10 million) and large VARs regard consulting as their primary source of revenue, up from 17 percent and 15 percent, respectively, three years ago.

That trend certainly rings true at Woodland Hills, Calif.-based Data Systems Worldwide (DSW), where consulting revenue has risen to roughly 20 percent of its total revenue for the company, according to CEO and president Phil Mogavero. Telling an all-too-familiar painful tale, DSW took a hit after the bubble burst, with revenue dropping from $25 million in 2001 to roughly $18 million this year. Mogavero, who had taken over the title in 2000 from his father, founder Frank Mogavero, found himself in the position of having to change the company, an ongoing process for him during the past four years.

"It was a change of strategy. It used to be project-based consulting. Now it tends to be more consulting on the front end--a lot more analysis," Mogavero explains. "We used to attach our people to projects. Now we attach them to a customer."

Mirroring other solution providers in many ways, DSW realized the do-or-die need to move away from technologies that were plagued by commoditization and to find niche plays, where margins weren't in the single digits. In DSW's case, it found financial strength in an integrated security solution it developed called Secure Network Application Platform.

Mogavero echoes the statements of many other solution provider CEOs by observing that he no longer has the luxury of working with one set of products--typically hardware--to bring home the bulk of revenue for his firm.

"Once, one sales manager could handle everything," he says. "Now, there are different managers for different levels--service, hardware, among others. They're of a much higher caliber, but they're also more expensive--about 40 percent more."

They also don't have the luxury of keeping tabs on their markets in one country. Specialization is great, but growth calls for developing your strengths wherever the market leads you. Take Reynolds and Reynolds. After the European industry changed automotive retailing regulations and dealer consolidation accelerated, the Dayton, Ohio-based integrator knew it had to change to take advantage of new opportunities. According to Doug Ventura, Reynolds and Reynolds executive vice president of operations, manufacturers can now expand channels and dealers can sell multiple brands.

The key to capitalizing on these new opportunities rested on a technology platform that could be rapidly localized and deployed across multiple countries and languages. And Reynolds knew it didn't have the goods, so it identified Incadea, a provider of global automotive retailing solutions, as an acquisition candidate, Ventura says. The change called for Reynolds to expand an existing alliance with Microsoft.

"The incadea.engine platform is built on Microsoft Windows and Microsoft ERP Business Solutions Navision to collectively take the platform to market," he says. In addition, Reynolds leveraged Incadea's existing partner network, nearly 3,500 users at 200 dealers, which reduced the need to hire a sales force or build an expansive services organization.

"Expansion has now reached Mexico," Ventura says, where Reynolds is now reselling the platform to BMW car dealers alongside IT Soluciones, a Mexican-based technology company, and further leveraging start-up costs it needed to change.

Where Profits Are Coming From

Concurrently, and not surprisingly, VARs have been making more gross profits from services than from hardware in the past 12 months. Roughly, the mix during 2004 for small VARs, specifically, is projected to be 61 percent derived from services, 17 percent from hardware and 22 percent from software, according to our research. That's quite a change from the results of three years ago, when small VARs told us that only 46 percent of their gross profits came from services, roughly 37 percent came from hardware and 17 percent came from software. That similar shifting trend holds the same across all VARs, regardless of revenue size (see "Emerging Gross Profits,").

"Hardware will continue to be soft...the real opportunities are in the services segment," says Matthew J. Espe, CEO of Ikon Office Solutions. After joining the company two years ago from GE Lighting, he decided to turn his mammoth New York Stock Exchange-traded $4.7 billion company into one that focuses on services. "We have gone from being a distributor to being a service provider," he says.

To that end, Ikon debuted in mid-September an integrated solutions portfolio, teaming up with preferred vendors, including EMC, to broaden its appeal to potential customers. Services now represent $2.3 billion in annual sales, roughly half of the Malvern, Pa.-based company's annual total, and provides a paycheck for 16,000 Ikon employees. It's no surprise that Ikon, like so many other solution providers, is looking to services to grow the company.

"There's revenue softness throughout the company," he says, though his professional services is growing at 40 percent.

Meanwhile, Evolving Solutions' Gmach says his company has never had an unprofitable quarter, and he predicts sales will climb to $64 million next year. Services now make up more than 20 percent of its revenue, up from only 5 percent a few years back. Yet, even with its up-to-the-minute model, net profits are down from 10 percent from seven years ago. Gmach attributes that to one thing--declining margins, acknowledging that if net profits hit 3.5 percent this upcoming year, he would be satisfied.

Similarly, Atlanta-based SpyderWeb CEO Kimberly West decided she had better evolve away from hardware when she saw a Dell presentation two years ago and realized the downward pricing pressure it was putting on hardware no longer made that business worthwhile.

"We knew things were changing. You could tell with things like Comdex. Last year, the second the show started at the registration desk, you just knew the show was over," she recalls.

West and her team proceeded to regroove with a two-year transformation, only recently completed, that rotated SpyderWeb 180 degrees. Today, her company gets more than 90 percent of its revenue from IT consulting and integration services, and carries almost no hardware. This cost the company some revenue (to date, it's at roughly $2 million in sales), but West says the business is growing heading into 2005.

"We've learned that with high-margin services, you can have a successful business that focuses on utilizing and optimizing the existing IT infrastructure that your clients have, rather than pushing them to buy new stuff," she says. "SMB spending in small towns and rural regions is on its way up, and we'll top this year's numbers in 2005."

While all VARs are increasing their government revenue, it seems small and midsize VARs are catching up with larger VARs, possibly cutting into their market share and/or enjoying more dollars from a growing number of projects. Just two years ago, small VARs responding to our State of the Market questionnaire reported an 11 percent gain in government revenue. This year, that increase skyrocketed to 47 percent. Midsize VARs reported a 31 percent increase in government revenue, compared with 9 percent in 2002. Both outpaced large VARs, who said government sales are estimated to be up 22 percent in 2004, compared with 11 percent in 2002 (see "Government Gains").

"A lot of companies benefited from continued budget increases at the macro levels, which were driven by the war," explains Steve Charles, executive vice president and co-founder of Immix Group, a government solution provider that posted a 100 percent sales increase this year. With top-line revenue of $77 million for its fiscal year ended May 31, it's shooting for the $100 million mark. "As soon as we get the war wrapped up, budgets will dip," he adds. "In coming years, people will need to be smarter [about] who will be successful in this marketplace. [Companies that] stick around will be those integral to the programs they sell into."

The Shrinking VAR

But no matter its size, the life span of a VAR is shrinking. Perhaps due to acquisitions, new VARs entering the market or a challenging market, large VARs in 2001 said they had been in business an average of 20 years. Just three years later, that number has declined 25 percent to 15 years. Similarly, midsize VARs dropped from 13 to 12 years in age, and the average number of years a small VAR has been in business, according to our most recent survey, is nine, down from 11.

Despite their age or size, however, the one trait all these VARs have in common is their desire to partner. In fact, more solution providers--approximately three-quarters regardless of annual dollar volume--are doing just that. Our study found that in 2004, 27 percent of all revenue generated by small VARs came from a partnering engagement. That's up almost nine percentage points from 2001. Midsize VARs derived 25 percent of their revenue from partnerships this year, also up from 18 percent in 2001. And large VARs said revenue from partnership relationships climbed to 24 percent this year, up from 18 percent three years ago.

Linda Rose, CEO of San Diego-based Rose Business Solutions, believes partnering is essential given the rapid interest in solutions that serve the midmarket. Accustomed to larger accounts, Rose picked up a 12-store retail customer needing both back-office accounting and point-of-sale solutions. Microsoft, a main vendor partner, fixed Rose up with Phoenix-based POSitive Technology, which knew Microsoft's Retail Management System, she says. Change was inevitable and, in this case, difficult at times.

"Since both firms were strong organizations used to managing their own projects, the partnership had a bit of a rocky start," she admits. "But, like a good marriage, we both learned to trust one another, and that decisions made by one were in the best interest of all parties."

Rose, however, acknowledges that neither firm would have been given the opportunity independently, a fact our State of the Market research confirms. She advises those considering partnerships to assign one project manager only; start small, if possible, to test the partnership; and that even if the partnership starts at the sales level, to make sure it's embraced at the ownership level. Partnerships, she says, are key to future growth.

It's also fortunate for solution providers trying to hold on that workers' salary demands have eased, and will continue to do so, as offshore workers continue to threaten domestic job security.

"It is certainly a better environment for the employer than it was five years ago when salary demands were high," says Bill Henry, president and CEO of Budco, a Highland Park, Mich.-based business process outsourcer with $100 million in annual sales. "Here in Southeast Michigan, salaries are going up 3 [percent] to 3-and-one-half percent a year. We're certainly not losing people to competitors."

Similarly, Mogavero notes that, for the most part, salaries have been flat.

"Salaries for application developers have actually declined from about $80,000 to $60,000 because of competition from offshore markets," he says. "Database administrators still make about $120,000, but that number has fallen back for those who aren't as good. Workers who build enterprise-class networks are getting paid about $100,000. That number has gone up a very little bit."

Revenue Goals
No doubt about it, things have gotten better. This time two years ago, revenue goals were below projections for almost half (48 percent) of all small and midsize VARs and more than one-third (36 percent) of large VARs. That number has declined to 24 percent for small VARs, 20 percent for midsize VARs and only 14 percent for large VARs during the second half of 2004.

Even better, this year many more VARs, regardless of size, say they expect sales to be ahead of projections for the second half of 2004 compared with VARs answering that question in 2002. Almost one-third of midsize VARs (31 percent) expressed that belief compared with 17 percent in 2002. Twenty-seven percent of large VARs said they expect sales to be ahead of expectations, compared with only 15 percent in 2002. Small VARs appear to be the least optimistic: Only 19 percent think sales will be ahead of expectations, but that's still more than the 12 percent who thought so during the second half of 2002 (see "Reaping the Rewards").

Like the majority, Budco's sales, whose fiscal year ends Feb. 28, are up from last year, albeit a little behind internal goals, Henry says. Roughly 75 percent of its business comes from the local automotive industry, which he says is watching its costs. One automaker, for example, held off on a substantial IT business-process consolidation because of internal budget cutbacks.

Still, "Budco is optimistic about the first half of 2005 with a number of substantial opportunities in the pipeline from Fortune 100 clients," Henry says, adding that his 200-seat call center hasn't run into offshoring pressures, a circumstance he attributes to its limited size. "We haven't had pressure from clients, and we knock on wood for that. The things that are going overseas are substantial applications."

Looking ahead to the coming year, 32 percent of small VARs, 26 percent of midsize VARs and 19 percent of large VARs said they expect revenue to increase during the first half of 2005. That's an increase across the board over last year, although only by 1 or 2 percent across all categories.

The most optimistic of VAR are those that have learned to not only cope with change but embrace it.