Is This Feast or Famine?

As the general economy continues to lurch toward what the Federal Reserve Bank hopes is a soft landing that will ward off inflation, the question many folks in the channel are trying to resolve right now is whether this is a period of feast or famine.

Clearly, you don't have to look too hard to find solution providers that have had difficult second quarters that are now being extended into the third quarter. But at the same time you can find just about as many solution providers that say they are thriving. So you have to begin to wonder what's going on here.

At the risk of overgeneralizing, one common theme that appears to be at work is that solution providers that depend more on hardware sales are having a much tougher time than solution providers that have software specialties or have made a transition to delivering a robust set of high-margin managed services.

While it may be tempting to think that pressure on hardware sales will eventually lighten up, we may be in for a much more extended period of depressed hardware revenues than most people expect.

The first source of pressure on hardware sales of course is the extended wait for and rollout of the Vista version of Windows. Although Microsoft will ship this long-awaited version of Windows in January, customer adoption of a major new operating system is going to be an extended affair that will reach deep into 2008. That means the pressure to upgrade business PCs is going to be relatively limited over the next six months.

Meanwhile, on the server side of the hardware equation we're seeing increased sensitivity over server utilization and power consumption. So while economic conditions today are the main reason we're seeing pressure on server sales, going forward issues surrounding power consumption and virtualization are going to play a bigger role in server economics.

In short, most IT organizations are going to be looking for fewer, more powerful servers to run a larger number of applications on top of a virtual environment that they expect will be easier to manage. For solution providers, this means selling fewer, more powerful, energy-efficient dual-core machines at prices and margins that will be roughly equal to what they saw a year earlier for significantly less powerful machines that were sold in more abundance. As McKinsey & Co. put it in a survey of 77 IT executives, spending on IT hardware is continuing, but because organizations are buying larger machines that have higher utilization rates thanks in part to virtualization software, the total amount of spending on hardware appears deceptively flat.

Next page: Overall IT spending is growing.

The news here isn't all doom and gloom, it's just a strong indicator telling solution providers that they need to rebalance their portfolios. On the positive side, chief financial officers at major corporations expect that they will be increasing the amount of money they allocate toward capital spending by as much as 8 percent, according to a recent survey by Goldman Sachs.

Furthermore, as IT takes up an increasing amount of the capital spending budget, the percentage of revenues that is being spent by companies on IT is also steadily increasing. For example, median corporate IT spending in 2006 across all industry sectors in the United States and Canada is 2 percent of revenue, according to the 17th annual Computer Economics IT spending and staffing study. The 2 percent ratio is an increase from 1.7 percent in 2005, and above the 1.9 percent figure from 2004. In fact, this year's ratio is the highest that this metric has reached since 1997, during the build-up to Y2K, when it reached 2.2 percent.

Effectively, the growth in IT spending as a percent of revenue means that IT budgets are increasing faster than corporate sales. This is confirmed by the study, which shows that the median growth in IT spending on a dollar basis across all respondents this year is 4.1 percent, outpacing the 2005 U.S. GDP growth rate of 3.5 percent in 2005.

What's driving this upward trend is the fact that as more business processes become dependent on the Internet for execution, companies are finding that for all intents and purposes, IT is now the new backbone of the company. In effect, this means that every new business process essentially creates a related IT event that needs to be funded. As a result, IT spending will hit $496.7 billion in the United States and $1.3 trillion on a worldwide level by 2009, according to IDC, with communications and media, health care, financial and consumer markets gaining the most ground.

Other findings in the study suggest that government and discrete manufacturing will continue to be the biggest spenders. The U.S. government will spend heavily on IT services as it privatizes large deployments that were previously controlled by government employees, while globalization will be a major driver for investment in the manufacturing industry, with companies centralizing ERP (enterprise resource planning) systems and buying more network equipment. More specifically, AMR Research says it expects manufacturing companies to increase IT spending by 3.7 percent in 2006.

Even more interesting are the responses as to which enterprise software investment in 2006 is considered "most strategic." ERP comes first, according to 33 percent of companies, but manufacturing operations is tops for 21 percent of respondents, followed by supply chain management (15 percent) and customer management (14 percent).

The McKinsey study also sees a new wave of ERP enhancements driving IT spending: 47 percent of the respondents say they are budgeting substantial investments in ERP for the coming year. The top priority is sector-specific enhancements to basic ERP platforms. Most large companies have already implemented the basic elements of ERP systems to manage materials and core operating processes and to generate financial metrics.

Now many CIOs report that they are building extensions to these systems to improve the productivity of sector-specific operating processes and to address competitive issues in their industries. Retailers are investing in ERP extensions that help managers maximize sales by deciding when and how much to mark down prices.

CIOs also plan to invest more in business intelligence tools, including applications that extract data from ERP systems and allow users to analyze customer or market trends in finer detail. And they are enhancing the finance and accounting modules of their ERP systems to comply with governance regulations such as Sarbanes-Oxley.

In fact, a separate McKinsey survey conducted with the Sand Hill Group predicts that software in general will rise to consume 35 percent of the IT budget in 2008, a five percent increase over a two-year period, with the majority of spending on new applications being driven by midmarket customers rather than large enterprises.

That estimate is also reflected in a CIO Insight spending survey that finds that IT budgets in 2006—when weighted to reflect the fact that small and midsize companies far outnumber large companies, which have giant IT budgets—are up by 5.4 percent over 2005.

So if spending isn't dramatically off, but rather being reallocated, solution providers should be thinking long and hard about their offerings. In yet another study, CIO Insight readers say that the emerging technologies that are likely to have a major impact on their organizations are dual-core processor systems; software-as-a-service offerings; server and storage virtualization software; service-oriented architectures; open-source development tools; search tools; collaboration software; and mobile computing products and services. In contrast, spending on security and compliance should be leveling off but not decreasing substantially given the large sums of money previously spent in these areas.

The long and the short of all this is that solution providers can either follow where IT spending is going or attempt to get ahead of what appears to be a major shift in the IT tectonic landscape that will favor more applications running on fewer high-performance systems. And as everybody knows, it's a lot more fun to lead the parade than clean up after it.

Michael Vizard is editorial director of Ziff Davis Media's Enterprise Technology group. He can be reached at michael_vizard@ziffdavis.com.