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Global: Technology: IT Services
Equity Research
India trip confirms offshore’s secular growth, but landscape is fluid
India research field trip covers all major offshore delivery cities
Last week we traveled to India and visited IT services companies in Delhi,
Mumbai, Chennai, and Bengaluru. Our trip provided us with increased
confidence that offshore’s secular trajectory is well intact with various
factors enhancing/expanding the long-term prospects for global service
delivery. Admittedly, evolving industry dynamics, labor supply, changing
competitive landscape, and India’s developing infrastructure are key
structural cross currents to navigate.
Expect outperformance on leading growth and cycle positioning
We believe that the forces driving offshore and global service delivery
remain strong and this should fuel outperformance for selected names
with exposure to this powerful wave. We base our view on four factors.
(1) At 15%-20% expected long-term revenue growth, offshore remains
among the fastest growth areas for technology investing anchored by low
penetration of the model, favorable technology trends, and constrained IT
labor supply. (2) Into 2011, the late cycle dynamics of offshore should
support current valuation. (3) Robust fundamental profiles with offshore
models offering intact EBIT margins, solid FCF growth, and industry
leading returns. (4) The relative scarcity of direct investment options in
offshore is expected to keep intact the premium valuation for the group.
CTSH is the most levered to offshore’s secular growth
Within our the US IT Services sector Buy-rated CTSH is the most leveraged
to offshore’s secular growth, expected to drive 30% revenue growth in
CY11. Buy-rated ACN and CL-Buy SAPE are also well-positioned with half
of their headcount located in global delivery centers. Although the longterm prospects for offshore BPO are intact, demand trends are lumpy.
HCLT.BO – top pick in Indian IT services; 2011 pipeline better
We highlight HCLT as an undervalued stock. We forecast its two-year
revenue CAGR (FY11-FY13) to be slightly higher to large-cap peers at 18%,
supported by management’s statement that its pipeline for 2011 was larger
than 2010. Despite offering a higher EPS CAGR of 23% (FY11-FY13), HCLT
is trading at 36% discount on one-year forward P/E to its large-cap peers
which trade at 21.5X. We are Neutral on Infosys, TCS and Wipro on
valuation and expect further stock performance to be driven by sustained
volume growth against the backdrop of stronger global tech spending
Secular growth of offshore should drive outperformance in 2011
Last week we traveled to India and visited IT services companies in Delhi, Mumbai,
Chennai, and Bengaluru. Our trip provided us with increased confidence that
offshore’s secular trajectory is well intact with various factors enhancing/expanding
the long-term prospects for global service delivery. Admittedly, evolving industry
dynamics, labor supply trends, changing competitive landscape, and India’s
developing infrastructure are key structural cross currents to navigate.
Coming out of our trip we offer the following key takeaways.
Offshore remains a key secular growth area in IT service delivery with intact budget
cycles and pipelines driving high confidence into 2011.
On the labor side, trends discussed appear relatively stable as hiring shifts back to the
campuses, away from lateral hiring. Given this shift in hiring and more balanced
supply-demand balance, wages are expected to normalize into 2011
Near-term drivers are anchored on non-technological drivers, with core systems works
driving material volume growth. Emerging technology impact to revenue growth
prospects remain relatively nascent, but important for long-term prospects.
On the competitive front, the nature of competition is changing to the front-end with an
increased focus on consultative selling and more effective account management.
Non-linear models, new service offerings, and emerging markets are key to long-term
growth initiatives, but most remain relatively nascent. China remains an opportunity
and a threat; but still far off.
Long-term BPO growth intact, but demand trends appear lumpy as client expectations
continue to evolve to measured business impact.
Currency seen as the largest risk factor for next year.
Against this backdrop we believe that the forces driving offshore and global service
delivery remain strong and this should fuel outperformance for selected names with
exposure to this powerful wave. We base our view on four factors:
1. At 15%-20% expected long-term revenue growth, offshore remains among the fastest
growth areas for technology investing anchored by low penetration of the model,
favorable technology trends, and constrained IT labor supply.
2. Into 2011, the late cycle dynamics of offshore should support current valuation.
3. Robust fundamental profiles with offshore models offering intact EBIT margins, solid
free cash flow growth, and industry leading returns profiles.
4. The relative scarcity of direct investment options in offshore names is expected to keep
intact the premium valuation for the group
Key industry takeaways confirm an intact environment
Offshore remains a key secular growth area in IT service delivery
While there is no doubt that a portion of the growth experienced in 2010 was a function of
pent up demand and the cyclical recovery of IT spend, we also attribute much of the
growth to favorable secular forces. Specifically, from an addressable market perspective
the absolute penetration of offshore remains low. Consider the latest estimates by India’s
technology trade association NASSCOM which suggests a total market opportunity of $300
bn-$400 bn with current industry revenues sized at $50 bn-$60 bn, the absolute penetration
for offshore services remains well under 20%. In addition, the addressable market
opportunity is expanding as offshore companies target new service offerings (e.g.,
infrastructure, BPO, consulting, etc.) and focus on penetration of new markets (e.g.,
Australia/New Zealand, Latin America, China, etc.). At this point, offshore’s value
proposition is firmly cemented as an integral part of service delivery models as enterprises
continue to grapple with operating cost constraints and the need to invest in new growth
initiatives and technologies.
Intact budget cycles and pipelines drive high confidence into 2011
The demand commentary from the companies that we met with was unanimous with all
companies confirming a robust demand backdrop into the end of 2010. When we pressed
the companies on expectations for 2011, the commentary was consistent in echoing
expectations for sustained growth, with most basing their growth expectations on normal
budget cycles and intact pipeline efforts into next year. Anecdotal commentary suggested
that visibility into 2011 was better at this point when compared to same point in time in
2009 and looking ahead to spending intentions for 2010.
Labor dynamics appears relatively stable; shift to campus hires
One of the more concerning trends over the last two quarters has been the marked uptick
in employee attrition for nearly all companies in the space. Looking back, it is clear that the
uptick was a function of the rapid snapback for demand, with most companies caught
unprepared to meet increased demand. As a result, most ended up resorting to increased
lateral hiring or outright poaching of competitor employees to meet client requirements;
these efforts resulted in a skew of recent hires to laterals which exacerbated the employee
attrition backdrop. Based on our conversations, it appears that many of the factors that
drove attrition higher have normalized, although the demand backdrop remains high the
supply planning cycles appear more appropriately tuned, with most of the companies we
met with indicating that the worst of employee attrition was now behind them—the peak of
attrition was experience in the month of July by most.
Looking ahead, most of the companies appear focused on returning to a better balance of
campus and lateral hires, which in turn should help ease some of the pressure on
employee attrition. That being said, most of the companies recognize that the robust
nature of the current demand backdrop will likely keep attrition at slightly elevated levels,
but not quite the recent peaks experienced in 2010. Given the large supply of new campus
graduates, there appears to be ample labor supply to meet demand requirements, however,
some of the smaller companies that we met with did express some concern about being
able to find, recruit, and retain the right talent.
Wage inflation cycle expected to normalize into 2011
Following two years of relatively stagnant wage increases and promotion cycles, 2010
experienced a higher level of wage inflation, however, much of this appears to have been a
function of catch-up as well which was made more acute by hiring trends which shifted to
laterals in order to meet demand. Into 2011 it appears that most of the companies are
planning for a more normal wage cycle with average wage inflation expected to finish up
in the 10%-15% range. As is typical the composition of these wage increases will remain
weighted to the more experienced labor base, with campus wages for new hires expected
to remain relatively flat. Against a robust demand backdrop and aggressive hiring plans
articulated by most this labor supply dynamics could end up an acute source of margin
disruption if the companies are not able to effectively offset with pricing leverage of
operating efficiency. On balance, however, we noted more concerns about wage inflation
from the smaller companies we met with, where more explicit concerns about their ability
to manage growth and meeting hiring requirements was expressed.
Near-term drivers are anchored on non-technological drivers…
In the near- to medium-term the drivers for the industry’s growth profile are anchored on
both macro and non-technological forces with regulatory/compliance efforts at the top of
the list.
From a macro perspective, we continue to see a clear dichotomy in performance with
the US and emerging markets driving the majority of global growth expectations.
Although the US economy continues to face challenges, US corporate profitability (as
measured by the S&P 500 companies), remains strong and provides a positive bias to
technology spending; with 70%-75% of revenues derived from US companies this
remains the key market for sustained growth prospects of offshore models.
While labor trends remain sluggish overall with relatively weak hiring trends and high
unemployment, labor constraints and resource availability for IT resources continues
to fuel demand for offshore labor. Finally, we believe that the protracted nature of the
recent downturn has forced many large enterprise to further contemplate global
services delivery as cost efficiency, below trend budget growth, human capital
constraints, and the need to invest in new growth initiatives and technologies
resonates well with offshore’s value proposition.
Changes in regulations and new compliance requirements are driving clients to
revamp systems and processes; this is most relevant in the financial services industry
which remains the largest end-market contributing 30%-35% of industry revenues.
Health care reform in the US was also cited as an important driver for new tech
spending as companies revamp systems to conform with new reporting requirements
for employees and health care provisioning.
Post-M&A integration continues to provide an important driver as enterprises drive
system and consolidation efforts. Other important non-tech issues faced by enterprises
and cited as demand drivers include continued globalization efforts, including
investments in emerging markets which require the rollout of new enterprise systems.
Volume growth remains weighted to core systems work
Given their core competency in core ERP systems and other enterprise applications,
volume growth remains weighted to work from ERP integration, systems consolidation,
development, maintenance, extraction efforts (e.g., analytics, data mining, business
intelligence, etc.) and upgrades; with one company citing that they were “sold out” in
some ERP resources. As we move into 2011, there is a clear path in the spending cycle
which is expected to shift the focus from application development efforts, which helped
fuel 2010, to more application maintenance efforts in 2011 consistent with later cycle tech
initiatives for most enterprises.
Emerging technology impact remains relatively nascent
Over the last two years we have focused on multiple waves of technology changes
impacting global enterprises. Specifically, we have discussed various technology trends
including virtualization, cloud computing, SaaS, Web 2.0, and mobile deployment efforts
(refer to our November 4, 2009 report titled “Technology changes to drive 2010 spending,
while cloud dynamics could alter IT delivery”). In our conversations last week, many of the
companies we met with confirmed that these remain viable drivers; however, the relative
impact of these technologies remains relatively nascent. Incrementally, the companies
appear more focused on the rise of the digital consumer, proliferation of mobile
technologies, and increased impact of social technologies as more important near-term
drivers, as they are more directly impacting the ERP systems and applications addressed
by offshore companies. At this point the enterprise impact of cloud initiatives and SaaS
models appears limited in core applications, but the companies did cite customer
relationship, salesforce, and human capital management as the areas in which they are
seeing the most spend, although the impact remains low for the offshore models.
Nature of competition is changing to the front-end
In what was the most clearly articulated perspective during our trip the CFO of one of the
companies we met with made the point that in order for offshore vendors to survive longterm commoditization they needed to change their selling approach “order taker mentality,
to one of a demand generator.” Although a very simple observation at its core, it also
reflects a monumental shift in the thinking that appeared to permeate nearly all of the
companies that we met with. This recognition reflects a confluence of factors including
increased client maturity/sophistication with global delivery models, increased competition
from large MNCs, and evolution of offshore models to higher value-added services
requiring improved front-end skills.
Against this backdrop, the companies we met with articulated various strategies to further
develop front-end capabilities including a focus on consultative selling driven by clientpartner models. As such, many of the companies are focused on increased hiring of
seasoned client executives offering deeper industry knowledge or specific domain
expertise. In addition, many of the companies are focused on improved alignment between
account executives and delivery organization to improve client penetration. In general, it
appears that most of the companies have concluded that demand generation will require a
new value proposition heavily dependent on improved industry and domain expertise and
more effective account management to drive more effective client penetration.
Non-linear growth mantra continues to evolve; but still early
It has been a few years since the concept of non-linear growth was first articulated as a
requirement for the long-term viability of offshore models that remain heavily dependent
on pure labor growth and head count additions to drive revenue growth. Despite much of
the talk to move to non-linear models these efforts remain relatively early, but the
imperative to shift to non-linear growth remains high as some of the larger companies in
the space have now broken over 100,000 employees and a few well on their way to the
200,000 barrier. From a revenue contribution perspective non-linear revenue contribution
remains well under 10% and mostly relegated to smaller software product offerings. That
being said, the prospects for non-linear models remain high and appears to be taking on
many forms with companies continuing to explore a range of delivery options including
platform-based solutions, managed services offering, and point solutions with SaaS-based
delivery.
New services and markets key to long-term growth initiatives
Over the course of the last few years the growth prospects of the offshore model have
been augmented by the successful introduction and adoption of new services and
capabilities, which have expanded the total addressable market for offshore services.
Specifically, we have experience a move from application maintenance/outsourcing to
application development, systems integration, infrastructure management, and business
process outsourcing; all of which have been important in helping rounding out the
industry’s high growth rates. Looking ahead, further penetration of these services in
addition to the successful ramp of new services offerings in knowledge process
outsourcing and analytics will be key for sustained growth opportunities. Interestingly, in
our trip there was some debate and disagreement among the companies we met with
about the relative importance of consulting as an addressable growth area and this was a
point which was clearly inconsistent with the requirement to move to higher value selling
and deeper industry/domain expertise requirements. Regardless, we believe that
consulting remains a relatively untapped segment for the offshore companies, which
provides access larger more transformative engagements and can be a feeder for the more
traditional areas of application outsourcing and development.
Long-term BPO growth intact, but demand trends appear lumpy
Takeaways from the trip reinforces our view that the long-term secular growth for offshore
BPO remains intact, with most companies citing BPO as one of the top areas of ongoing
investments and recruiting. That said, demand trends will likely remain lumpy in the nearterm, as customers appear to be focusing on IT and faster payback projects that require
less upfront investments. Similar to IT, the focus on offshore BPO services appears to have
shifted from pure cost arbitrage to business outcomes. As such, factors including domain
expertise, process excellence, the ability to leverage technology to enhance operating
efficiencies, and project management skills will be paramount in ensuring the long-term
success of the BPO model and become major differentiating factors among service
providers.
China remains an opportunity and a threat; but remains nascent
Consistent with the findings of our recent trips to China we found little evidence that this
market is ramping ahead of our expectations. There is no doubt that China will be an
important long-term market, however, most of the companies are very early in their efforts
to scale this market. Clearly the domestic opportunity is large, however, they track that
most seem to be pursuing in China is to use it as development and support center for their
broader Asia efforts including servicing Japan and other countries. In the interim, we
believe that the domestic Chinese IT vendors remain advantaged in penetrating the
domestic market opportunities. From a competitive perspective, China is the only country
with the labor supply and talent to compete effectively against India, and therefore we
expect that its prominence will only continue to rise as current efforts by the Chinese
government to improve language skills and expand capabilities will eventually take hold.
Currency seen as the largest risk factor for next year
Indian offshore service providers cite currency volatility as the single largest risk over the
next year. Due to increased volatility in the currencies (USD, GBP, EUR, JPY, AUD, and INR)
over the past two years, companies have moved towards shorter horizons for hedging their
currency exposures. Some companies have even stopped taking hedges due to increased
uncertainty over the direction of currencies. Managements maintain that small moves in
currencies can be managed over a period of time but material fluctuations pose risks to
margins. With fluid economic conditions in EU and dynamic fiscal and monetary situation
in India, cross currency exchange rates and INR continue to pose risks and uncertainty over
margins and profitability.
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