What is the profitability picture for solution providers today? The answer depends on factors such as business model, customer and technology focus, geography served and business execution. By and large, however, solution providers with significant amounts of recurring revenue report excellent profitability.

"It is strategic to increase recurring revenue," says Jane Cage, COO of Heartland Technology Solutions, a solution provider with multiple locations. "We have always looked to it as the foundation of our profitability."

At Heartland and other solution providers around the country, managed services are leading the way to new heights of recurring revenue -- not only in volume, but in profitability. "It's much easier to run a profitable business when you've got a predictable income stream, and managed services offer that," says Ross Crane, senior VP and CFO, Ingram Micro North America.

"The profitability of the managed services business is very good," agrees Joe Popper, president of Computer Gallery, a managed services provider (MSP) focused on small business. "The recurring revenue allows you to build a predictable and profitable business model, compared to the reactive way of doing business, where you sit and wait for the phone to ring."

"Our profitability is higher than most solution providers'," says Steve Harper, president of Network Management Group, a solution provider involved in several businesses, including managed services. "If you don't have recurring revenue from services that create uptime for your customers, you're not in a profitable business model.

Besides profitable recurring revenue, MSPs are finding that managed services offer additional bottom-line benefits, such as:

• higher profits on product sales and projects
• greater ability to leverage technical resources
• more strategic customer relationships

Still, managed services represent a paradigm shift from the traditional way solution providers do business. But MSP converts have found that the recurring revenue and other pluses more than compensate for the difficulties in making the shift -- as we'll see from those whose insights we share here. (Also see Ingram Micro Channel Advisor, Dec. 2006, "Best Practices in Managed Services."

Recurring Means Profits
Recurring revenue comes in many forms, such as maintenance contracts, software subscriptions and support, and regular service visits -- all good for the bottom line.

Harper first realized the power of recurring revenue from sales of e-mail management software developed in-house. Annual maintenance and upgrade fees started rolling in, and after a while "we had thousands of dollars a month of recurring revenue that we didn't have to sell every year," he says. "It was already sold; we just had to renew it.

"That's what happens with managed services," Harper continues. "If we do our job, if we make the customer happy, we sell it once and reap the benefits."

The benefits focus on higher profitability, says Tommy Wald, president of RIATA Technologies, a solution provider offering managed services for several years. "After I get a managed services account, I comp my sales guy only once, so to a certain extent my sales costs have dropped, and the business keeps building from there," Wald says. "We have found that the less of our gross margin we have to resell each month, the more profitable we are."

Compare this with the typical reactive, project-based solution provider, and the advantages are clear. Paul Dippell, CEO of Service Leadership, a consulting firm to solution providers, notes the tedium of having to continually sell project after project to grow the business. "Without recurring revenue," he says, "if you want next year to be twice as good as this year, you'll have to sell twice as many projects. Selling both is the key."

Higher Quality Revenue
Dippell also points out the higher profit potential of the recurring revenue from managed services, compared with revenue from recurring services, such as sales of block service time or hardware maintenance.

With maintenance contracts, the solution provider offers the customer an insurance-type contract, similar to managed services, where "the customer is going to pay whether it needs the service this month or not," Dippell says. "But maintenance is a point solution and doesn't put the solution provider in the role of being the virtual CIO, the trusted advisor. Thus, the level of account control, indispensability, stickiness -- whatever you call that special connection between the MSP and the customer -- is not as high."

Block service time suggests a different issue. Although the revenue is recurring, the service tends to mitigate against healthy profitability. "Block time for a fixed fee encour ages the customer to call even for minor problems, which can play havoc with your effective utilization of service staff," Dippell says. "When you sell the customer a service level with flat fee managed services, it's up to you to determine how much work it will take. You've broken the bond between time and rate. If you do it smarter with less work, you can boost both revenue and your gross margin."

Becoming a Hybrid
How profitable can managed services be? Gross margins from managed services are as high as 75 percent, MSPs report, far higher than from project work, time and materials (T&M) services, and product sales. Yet few have become pure MSPs. Instead, most embrace a hybrid model, where managed services co-exist alongside a traditional VAR business.

This makes sense because existing customers may be happy with typical VAR services -- it's easier to acquire new managed services customers than to switch the regulars. And offering managed services along with projects and products prevents an MSP's customers from seeking out other solution providers when they need, for instance, a server upgrade or a backup solution. Customers are likely to prefer a one-stop shop. "If you're hiring a gardener to come every week," Dippell says, "you'll probably ask him to plant the plants as well."

The main benefit of the hybrid model, however, relates to the potential of becoming a customer's trusted advisor. Once this status is achieved, products and project revenue often increase alongside the recurring revenue, with gross margins not seen in a long time. Says Dippell, "Benchmarking shows pretty clearly that when you get a managed services customer, you get more projects and product sales than you would if you tried to sell them individually."

The Trusted Advisor
MSPs working the hybrid model confirm this benefit. By leading with managed services, they more easily pick up additional, high-margin sales.

"As an MSP, we are becoming the IT department of many smaller businesses, their trusted advisor, and we are active in their long-term, infrastructure lifecycle planning," says Scott Goemmel, partner at PMV Technologies, a solution provider who leads with services. "This positions us to be integral to their product acquisition process."

Goemmel notes that because of the close relationship, many customers award product sales to PMV without bids, leading to above-average gross margins. "Our customers realize that they have many options for product procurement," he says, "but choose to work with our firm because they trust our judgment and clearly recognize that in an MSP arrangement, our mutual success is highly correlated."

At RIATA Technologies, Wald describes managed services as a springboard to profitable product and project sales, which still account for the larger part of his revenue. "As a trusted advisor, you own the IT, and you become deeply involved with the technology refresh cycle and the strategic planning," he says. "Before, we were just reacting to projects, but now we're driving the process. And margins are better because we're not really competing on price."

Wald notes that RIATA used to have to sell products at a 4 percent to 5 percent gross margin to get anyone's attention, but now he's consistently getting 10 percent to 12 percent because customers appreciate the value proposition of managed services. "They don't want to shop; they'd rather have someone like us take care of it for them."

Customers may be more willing to trust their MSP for project work because of the alignment of interests. "Managed services puts us on the same side as the customer, sharing the risk," says Steve Feldman, president of Graphtech Systems, an MSP who also does project work. "Even if the customer requests it, we're not going to put in an e-mail server that could cause problems, and they appreciate that."

Profitable Benchmarks
Research benchmarks from Service Leadership confirm aboveaverage profitability for hybrid MSPs, especially as the percentage of revenue from managed services rises over time.

• The average solution provider with 50 percent revenue from products, 40 percent from pro jects and T&M services, and 10 percent from managed services achieves an average pretax profit of 4.5 percent; best-in-class is around 13 percent.
• After a few years in managed services, revenue from products drops to 30 percent, revenue from projects and T&M services stays at 40 percent, and managed services bring in 30 percent. Average pretax profit rises to 7.8 percent and best in class to approximately 16.5 percent.
• Mature MSPs in business from three to five years bring in around 22 percent to 25 percent of revenue from products, 22 percent to 25 percent from projects and T&M services, and the rest from managed services. Average pretax profit rises to 11 percent, with best in class earning about 21 percent to 22 percent.

Mastering the Model
The key to such heady profits, of course, is mastering the MSP business model -- leveraging technology to the max and managing personnel by rewarding team efficiency rather than billable hours. "If you can add more customers without adding more employees," Wald says, "you really start driving revenue to the bottom line."

Remote monitoring and management tools play a crucial role. "In the past, you could expect an engineer to support, maybe, 100 desktops, but with automated management tools he or she could support 1,500 desktops," Feldman says. "As we move the customers from a model where we make money when they have problems, to one where we are more profitable when they don't, we have to become more efficient and effective."

This contrasts sharply with the traditional way of servicing customers "In the old way, which provides a bad level of service, you get into a situation where only Tony is familiar with the account, so you can only send Tony, and they only want Tony," says Popper of Computer Gallery. "That's a problem."

Instead, MSPs promise their customers a result -- such as an available, productive network -- so they focus more on business processes and team effort. "We've had to work very hard on the team approach and the communication," Popper says. "We don't have the cowboy-type employee anymore, and communication ensures that everyone knows what's going on at a particular account. We also try to make the customers more help desk-driven, training them not to expect to see a body whenever there's a problem."

Goemmel of PMV Technologies seconds this team-oriented approach. "The MSP model is about working smart," he says. "I value a staff member who can work efficiently and in tight alignment with our core purpose and values more than I value someone who feels that individual workload is more important than team productivity." Naturally, the nature of individuals hired and compensation incentives must reflect efficiency and commitment to the team.

Making the Hybrid Model Work
As challenging as the managed services business is, the large measure of profitable recurring revenue makes it worth the effort. MSPs who have been there advise a number of steps to ease the transition to the new business model:

• Be prepared for organizational changes and hard choices. "This new way of delivering services can be a difficult transition," Wald says. "Not everyone is going to understand it or want to come along for the ride." Some solution providers have segmented their MSP business from projects and products, assigning different staff to each business group.
• Gain perspective and advice by joining an industry peer group, such as the True Profit Group or Ingram Micro's VentureTech Network (VTN). Such groups routinely share lessons learned, best practices and profitability guidelines that make managing easier.
• Consider third parties to comp lement your own capabilities. Network Management Group, for instance, uses Ingram Micro's 24/7 post-sales technical support. "If we're on-site and we can't solve a problem in 15 minutes, we're calling Ingram Micro," Harper says. Also consider joining Ingram Micro's Seismic program for access to remote monitoring and management capabilities, as well as a knowledge base of best practices. (For more details, see above)
• Don't be afraid to shoot for the moon. "Once I realized that a solution provider could put 10 percent to 20 percent of revenue on the bottom line, that became my goal," Harper says. "It's a whole lot more fun when you're in that range."