MSPmentor

Anecdotal evidence suggests the managed services market is experiencing healthy growth. But the situation looks alarming at Computer Sciences Corp. (CSC), which is struggling in the managed services market amid missed SLAs (service level agreements), accounting adjustments and contract terminations, according to an SEC filing. CSC’s business challenges have triggered rumors that the company may break itself up.

When CSC announced disappointing quarterly results on Aug. 10, CEO Michael W. Laphen blamed the earnings miss on CSC’s manged services business. Laphen stated:

“This quarter’s margin results were adversely affected by performance within the Managed Services Sector (MSS). Improvement actions are underway within this business. Our other two lines of business delivered results essentially in line with our expectations. I am particularly encouraged by the revenue growth in Business Solutions & Services (BSS) which we’ve identified as our growth platform. We are very pleased to have closed our acquisition of iSOFT with its depth of quality healthcare resources and clients.”

The Deeper Story Emerges

CSC’s 10-Q filing with the SEC, which surfaced August 10, describes CSC’s managed services missteps in greater detail. The filing states:

“MSS revenue increased $21 million, or 1.3%, in the fiscal first quarter 2012 as compared to the same period in the prior year. In constant currency, revenue decreased approximately $91 million, or 5.7%, with currency benefits of approximately $80 million in Europe and $25 million in Australia.

Excluding the benefits from currency movements, the overall MSS decline was from a combination of contract conclusions and terminations of $78 million for the quarter, volume or scope reductions of $75 million for the quarter as well as approximately $35 million from missed service level metrics on an outsourcing contract and delays on certain development contracts. The decline was partially offset by new client engagements won in fiscal 2011 and 2012 which generated approximately $39 million in the first quarter of fiscal 2012 as well as $47 million of growth on existing accounts.

During the first quarter of fiscal 2012, MSS had contract awards of $0.5 billion, compared to $1.2 billion in the comparable prior year fiscal period. Awards included new contracts and successful recompetes.”

Accounting Questions

Elsewhere in the SEC filing, CSC concedes that its accounting practices for managed services required adjustments. CSC says there were no accounting irregularities or intentional misconduct. But the detailed filing shows some of the challenges related to managed services accounting. The filing states:

“During the first quarter of fiscal 2012, the Company’s Managed Services Sector (MSS) segment recorded five out of period adjustments primarily to cost of services, reducing income from continuing operations before taxes by $5 million which should have been recorded in prior fiscal years. Four of these adjustments totaling $4 million relate to MSS’ Nordic operations and $1 million to other MSS operations. The Nordic adjustments recorded in the first quarter of fiscal 2012 included two adjustments totaling $2 million which were attributable to an understatement of accrued expenses associated with vendor invoices related to fiscal 2011.  These adjustments were identified late in the fiscal 2011 closing process, and due to the immaterial amounts involved, were not included in the Company’s consolidated fiscal 2011 statements. The Nordic adjustments also included (i) $1 million of outsourcing contract costs amortized over a contract term (including an extension rather than just the original contract term) attributable to fiscal 2006-2012, and (ii) a $1 million error in the accounting for an operating lease attributable to fiscal 2010.  The $1 million operating lease adjustment is a refinement of an error previously corrected and reported in fiscal 2011. The $1 million adjustment related to other MSS operations was attributable to an understatement of accrued expenses in fiscal year 2011 due to an error in the calculation of management incentive compensation. In addition, MSS’ U.K. operations recorded a $4 million reclassification to reduce revenue and cost of services by offsetting amounts related to a fiscal 2011 fourth quarter adjustment resulting from a revised estimate at completion calculation. The Company attributes these adjustments to miscellaneous errors and not to any accounting irregularities or intentional misconduct other than the adjustment relating to the operating lease in the Nordic region, which the Company attributes to suspected intentional misconduct by certain former employees of our Nordic subsidiaries. The impact of these out of period adjustments was immaterial to the consolidated results, financial position and cash flows for the first quarter of fiscal 2012 and prior years.  Consequently the cumulative effect of these adjustments was recorded during the first quarter of fiscal 2012. As the fiscal 2012 out of period adjustments were immaterial, they have not been incorporated with the fiscal 2011 discussion below.”

Plenty of Problems

Read between the lines and CSC is basically stating that the company has been suffering from:

• Managed services contract conclusions and terminations;
• Volume and scope reductions;
• Missed SLA (service level agreement) metrics;
• Delays on some development contracts; and
• Accounting adjustments related to managed services.

That list of missteps and challenges is a timely — perhaps scary — reminder that managed services isn’t for the faint of heart. Negotiate a bad deal or deliver bad service levels, and you can wind up destroying your profit margins and hurting your reputation with customers.

Following CSC’s recent missteps, Reuters on August 12 suggested that CSC will seek to break itself up. CSC declined to comment to Reuters. But the company’s SEC filings certainly paint a challenging picture for CSC’s managed services business.

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