Desktop IV: Tech Refresh Gone Bad

There is less certainty around profit margins for IDIQs and tech refresh

P> Contractors always have viewed technology refresh as an easy way to earn millions by substituting the latest products at a higher price on an existing government contract. Until now. In fact, a recent Air Force decision questions the economic benefits of an industrywide practice on indefinite-delivery, indefinite-quantity contracts. Companies often underbid these IDIQ contracts and try to recover the high cost to bid them through a technology refresh clause.

Now, two contractors could lose millions if the Air Force sticks to its guns. The Air Force wants Government Technology Services Inc. and Zenith Data Systems Corp. to provide Microsoft Corp.'s Windows 95 free on their Desktop IV PC contract, which has a potential value of $1.1 billion. Air Force officials view Windows 95 as a product upgrade that doesn't allow GTSI and Zenith to increase prices, rather than as a new product substitution. Neither Desktop IV vendor would comment on the Air Force position. The Air Force was not able to respond by deadline.

Because there are few rules governing technology refresh, the decision puts reseller GTSI of Chantilly, Va., and manufacturer ZDS of Buffalo Grove, Ill., in a weak bargaining position. Furthermore, Microsoft Corp., the world's top software company based in Redmond, Wash., has no intention of providing the desktop operating system free.

Microsoft spent billions researching and developing the 32-bit operating system and consistently informed companies that Windows 95 was a new product and not an upgrade, said sources familiar with Microsoft. John Hand, government marketing manager for Microsoft, said the company could not comment because the terms of a contract such as Desktop IV and matters regarding upgrades are confidential agreements between Microsoft and the contractors.

But even if Microsoft provides free copies of Windows 95 to GTSI and ZDS, the two contractors will have to absorb more than $1 million in administrative costs, such as distribution and duplication of the product -- costs that cannot be passed on to the Air Force. Despite the potential losses, neither Desktop IV vendor appears eager to challenge the Air Force for fear that it might hurt their chances on the Air Force's next PC contract, valued at $750 million.

"This shows the potential for abuse of past performance," said Bob Dornan, senior vice president of Federal Sources Inc., a McLean, Va.-based market research company. "It can be used as a form of coercion to make a contractor do what it wouldn't normally do."

As a result, ZDS has pursued a different avenue to recover some of its potential losses. It has gone after its Desktop IV software supplier, federal contracting giant Electronic Data Systems Corp., Plano, Texas. ZDS filed a suit in January in Virginia's Eastern District Court in Alexandria to force EDS to provide the Microsoft product at no charge.

But Randy Dove, an EDS spokesman, said, "It's always been clear to us from the beginning that Windows 95 is a new product, not an upgrade." EDS would not renege on its pricing arrangement with ZDS.

Ironically, ZDS stands to lose more from the upgrade because of its sales success on Desktop IV. It has sold 205,000 PCs since it won the contract in February 1993, and 122,000 of the machines have office automation software installed, which makes those users eligible for the free Windows 95 upgrade. ZDS said it will give the PC users, as well as the 29,000 people who bought just the office automation software off the Air Force contract, free copies of the operating system.

The $525 million GTSI, the leading computer reseller to the federal government, should suffer less than competitor ZDS. GTSI sold 162,000 Desktop IV machines off the contract. More importantly, the company created an administrative hurdle that might help decrease the number of free upgrades it must provide. GTSI negotiated a clause in its contract, which requires users to complete and mail a registration form if they want a free Windows 95 upgrade.

To further reduce costs on shipping the 14 floppy disks that Windows 95 requires, GTSI will ship the operating system on CD-ROMs or use on-line distribution as much as possible, according to Harry Heisler, a consultant based in Chantilly, Va., and former vice president of marketing at GTSI. On Nov. 8, 1995, GTSI, unlike ZDS, began offering a CD-ROM drive with its IBM Pentium 100 mhz system.

Heisler thinks GTSI already accounted for the free Windows upgrades when it made its Feb. 8 announcement that it expects a $7 million to $8 million loss for 1995, with a $3 million loss resulting from Desktop IV.

Bill Loomis, a stock analyst with Ferris, Baker Watts Inc. in Baltimore, said, "In a worst case scenario," where GTSI could lose up to $5 million on Desktop IV, "it will hurt them in the short term, but it won't affect their relations with their banks, vendors or customers."

Although many sympathize with GTSI and Zenith, there is no consensus among Netplex observers about who is right. "The vendors weren't wise to agree to provide upgrades" at no charge, remarked Terry Miller, president of Government Sales Consultants Inc., Great Falls, Va. "It was a bad [request for proposal]. It's unfair to have a contract clause that's nebulous and hard to quantify. The contractors have no idea how many upgrades they will have to sell, when, how much it will cost them, etc...."

The Air Force first informed GTSI and ZDS in August 1995 that it expected to receive free copies of Windows 95. Despite objections from both companies, the Air Force directed them to deliver the software by early this year. When GTSI and ZDS didn't deliver, the Air Force, in an unusual move, threatened to levy contractual penalties, which include being in default of a contract. "It's not often that the government doubles up its fists and beats up on industry," said Miller, but it happened on Desktop IV.

And it could happen again.

Here's a Hot Tech Refresh

WT scanned the horizon for new products that looked like ideal candidates for insertion into ongoing contracts. Given the rush to use the Internet, and the notorious mishmash of computer systems in the federal government, we figured an ideal candidate would be a product that helps link this mishmash to the Internet. The product introduced most recently that seems to meet these requirements comes from Attachmate Corp., Bellevue, Wash. The company's product -- known as Emissary TCP Server -- connects older legacy systems operating on a network standard known as SNA to the Internet TCP/IP standard. So the product, which runs on Windows NT servers, is one building block for so-called "intranets" that use the Internet for running organizational computer applications.

The product could be a swap for existing "gateway" products on contracts that connect older mainframes to PCs running DOS and UNIX. The product is also ideal in that it's not cheap -- a 2,000-user license costs $65,000 -- so it promises high profit margins for resellers and integrators.

IDIQ Difficulties Make GSA Schedule Business More Attractive

The Desktop IV contract, valued at $1.1 billion, illustrates that tech refresh -- widely viewed as a fail-safe sales strategy -- isn't foolproof. Some contractors look to tech refresh as an opportunity to recoup the high costs to bid for the government's indefinite-delivery, indefinite-quantity contracts and to stabilize profit margins.

But because the government favors IDIQ awards to multiple vendors, some contractors have started questioning their business value.

After all, it can take millions to win an IDIQ contract. And if it's a dual award, the two winning contractors usually have no guaranteed minimum sales and still must compete against each other for the same customer base. Some companies describe an IDIQ contract as a "license to hunt," and not too different from obtaining a General Services Administration Schedule contract or 8(a) status, the set-aside program run by the Small Business Administration for minority-owned businesses.

Contractors who rely heavily on IDIQs are starting to see greater business value in GSA Schedule contracts, a procurement vehicle that has generated so much business recently that it has taken away business from 8(a) set-asides, open market buys and IDIQs, noted Bob Dornan, senior vice president of Federal Sources Inc., a McLean, Va.-based market research company.

"It's a rapidly changing world. A company that doesn't have schedule capability will have an uphill battle to maintain market share," he said.

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