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Part 1 of this series focused on price and valuation action during and immediately
following the 2008 recession and lessons for investors. In this edition (Part 2), we
investigate how: (a) IT services spending has behaved post-2008; and (b) Tier-1
Indian IT companies’ business models have evolved to manage volatilities and
complexities in IT spending since 2008? On both counts, we find a more assuring
picture.
One, we think IT-Services spending post 2008 has been largely disciplined
since coming off the previous financial crisis. Since 2008, US IT-Services
spending as % of US GDP has moderated signifying that excesses have not
been built in the system. Client firms, in general, have spent thoughtfully in the
last three years. Within the IT-Services spectrum, offshore IT services tend to
be least cyclical and are a much greater play on operations/IT than capex.
Two, there tends to be a period of client adjustment, typically spanning 2-3
quarters. Low global growth per se is not negative once the adjustment to the
new lower normal is made. Corporates (client firms), despite their better health
this time around, could take 2-3 quarters more to further adjust their business
priorities and calibrate (even trim) their IT spending if needed. Admittedly, this
period could be rocky for Indian IT but this readjustment phase paves the way
for acceleration of durable, sticky market-share gains for select vendors starting
mid-FY13. As per past data, crises tend to accelerate market share shifts in favor
of select players. Vendor consolidation is but one contributory factor to this.
Three, we see both push and pull factors at play. “Push” refers to Indian IT
selling its existing value proposition to first time outsourcers (FTOs) and newer
verticals in times of economic turmoil such as today. For example, Cognizant
believes that despite huge economic uncertainty in Europe, the offshore
outsourcing proposition has achieved penetration of just 10% there. “Pull”
relates to Indian IT enhancing its value proposition through forays into cloud
computing, analytics, mobility, more sophisticated methods of complex program
management, productivity-based pricing etc. Much of the appeal associated with
the Pull factor was developed/solidified in the past three years. The “pull”
factor does not get due recognition from investors, in our view. The silver lining
to the Lehman crisis was that players such as TCS/Cognizant have expanded
addressable market since then thanks to both the push and pull factors.
Four, we acknowledge the argument that corporates sitting on record cash and
profitability is not a wholly persuasive one (why would clients invest if demand
for their products/services is marked down?). Yet, we see another silver lining
here – clients will rush in with much better capacity than ever before to invest if
there is the slightest hint of stability or uptick in the macro-environment. Unless,
of course, a deep external shock intervenes (ala Lehman collapse).
Finally, valuations are getting to be supportive though not fully there yet.
Another 10% decline in prices of TCS/Infosys will essentially mean they have
just 2-3 years of 15% growth before they settle down to a perpetual growth of
5%, a conservative implication, in our view. We are buyers for at least 15-
20% returns over the next 9-12 months in select stocks. We back players
such as TCS (OW) that are best positioned to win durable market share gains.
We are slightly more constructive on Infosys (Neutral) than in the past due to its
much moderated valuations (more than 1 std. deviation below 5 yr. median P/E).
IT-Services spending post 2008 has been
thoughtful and disciplined
US IT-Services spending has moved as % of US GDP and
US corporate profits respectively since 2008 (the last financial crisis). IT-Services
spending as % of both GDP and corporate profits have moderated which suggests
that IT-Services spending post 2008 has been disciplined and thoughtful. During this
period (2009-present), Indian IT continued to handsomely gain market share which
suggests that the sector plays well to thoughtful, disciplined spending patterns of
clients.
Also, by implication, the room for enterprises to cut IT budgets is less this time
around than before (in other words, there is less excess to work off).
A crisis tends to accelerate durable
market-share gains for select players
poised to take advantage
Market-share gains in Indian IT tend to be durable, sticky and those who grab
them position themselves well for the next 2-3 years. The 2001-02 tech downturn
saw the Big 4 in Indian IT (TCS/Infosys/Wipro/Cognizant/HCLT) break away from
the pack. The 2008 financial crisis saw Wipro fall behind and Cognizant surge ahead.
Also, concurrently Accenture started playing aggressively using their India model
with much greater effectiveness emerging with share gains from 2008. Today, the
situation is no different. This downturn will likely create further separation among
this group of 3-4 players. In this context, we believe that TCS is positioning itself
well for the market share gains.
It remains to be seen how strongly Infosys (Neutral) emerges from the current
slowdown under the new leadership. Our view is that momentum once lost is
not easy to reclaim. The new Infosys management led by Mr. Shibu Lal has its
task cut out.
Market share gains for Indian IT accelerate during downturns as clients turn
even more disciplined in their spending. In terms of market share gains, Indian IT
companies gained market share by ~0.25% in the 1999-2001 period. However,
slowdown in 2001-02 led to increased focus on offshoring, and Indian IT gained
market share by ~0.5-0.7% every year in the 2002-2007 period. The market share
gains continue to accelerate after the CY08 downturn and Indian IT companies’
penetration level in global IT services spending has increased about 130 bps over the
last two years. We believe the current slowdown will further accelerate this market
share gain trend, due to the following:
1. Downturns force customers to cut costs/restructure business processes and
become more disciplined, thus leading them to look more closely at Indian
IT companies/offshore to cut those costs/restructure business processes.
This is a 2-3 quarter period of adjustment to overcome the initial
uncertainty.
2. Indian IT companies have increased the portfolio of their service offerings
over the past few years, allowing them to serve a much larger proportion of
IT budgets of customers.
3. Indian IT companies have grown bigger, allowing them to bid for larger
deals and thereby increasing the addressable market for Indian IT.
4. Indian IT companies have increased domain expertise in several industries.
In a nutshell, the addressable market for Indian IT continues to increase impressively,
and their relative positioning becomes more attractive over time. As a result, we
expect market share gains to further accelerate in case of a downturn.
How severe are issues on margins and
pricing during the current weakness?
The margin question –levers still exist to absorb pricing
declines in FY12E
Indian IT companies saw pricing pressure in the 2001-2003 downturn that led to
margin declines. As a result, EBIT and EPS growth lagged revenue growth.
Concerns have been raised about a similar compression in the current downturn. We
believe there are two facets of the margin issue:
1. Customers under stress could ask for price declines. This is a likely
scenario, in our view, and it is important to see how much cushion Indian
companies have to absorb margins.
2. Competition could cut prices and therefore require Indian IT players to cut
prices. We think this scenario is highly unlikely.
Overall, we believe Indian IT companies can largely sustain margins given a buffer
for FY12E. Continued pressures would, however, lead to a downward bias to our
estimates for FY12. Admittedly, the scope for SG&A rationalization and onsite-tooffshore transition is less this time around versus CY08/09, so the levers to manage
margins this time around (except growth itself) are fewer and/or less potent.
How meaningful can price declines get? Not a great worry
unless troubled customers force the issue much more
Pricing declines likely to be modest
It is conceivable that customers would ask for pricing declines in the weak economic
environment. In the last economic downturn, prices fell sharply for most Indian IT
players. However, we believe that extent of pricing declines could be lower than last
time as:
1. Post 2008, Indian IT companies have had tempered pricing increase. Most
price increases stemmed from COLA increases (cost of living adjustments)
rather than out-of-step increases.
2. A number of large customers are willing to offset pricing declines with
higher volumes and higher offshore volumes. In many cases, this is done by
converting T&M contracts to fixed price contracts. While this does pass on
execution risk to vendors, it helps Indian IT companies maintain margins
despite a lower price point.
Ways to offset price decline
We believe Indian IT companies have several levers to offset price declines.
1. Utilization for Indian IT companies is significantly below peak levels
achieved in 2001-2003 (except for TCS).
2. Recent rupee depreciation should help significantly in creating a margin
cushion for FY12E. We are assuming Rs44/US$ in our forecasts.
3. A good portion of current salaries (~15-20%) are variable, and reducing
these in the downturn could lead to cost cutting of 200-300bp.
We believe Indian IT companies could get strong tailwinds through these measures --
even to the extent of 200bp - that could absorb most of the pricing pressures.
Business model analysis: Select players
better placed than ever before
“Push” and “Pull” factors at play
“Push” refers to Indian IT selling its existing value proposition to first time
outsourcers (FTOs) and newer verticals in times of economic turmoil such as today.
For example, Cognizant believes that despite huge economic uncertainty in Europe,
the offshore outsourcing proposition has achieved penetration of just 10% there.
“Pull” relates to Indian IT enhancing its value proposition through forays into cloud
computing, analytics, mobility, more sophisticated methods of complex program
management, productivity-based pricing etc. Much of the appeal associated with the
Pull factor was developed/solidified in the past three years. The “pull” factor is
stronger than before and this does not always get due recognition from investors, in
our view. The silver lining to the Lehman crisis was that Tier-1 stocks such as
TCS/Cognizant have expanded addressable market since 2008 thanks to both the
push and pull factors. We explore both the “Push”.
Development spending is sustainable to a fair degree;
discretionary spending does not tail off at once
As clients look beyond cost-cutting and are engaging in IT spends to help drive
revenues (revenue-enhancement related IT initiatives), not surprisingly development
and discretionary spending has made strong come-back in the last 4-6 quarters
Will this sustain? We believe that the outlook on sustenance of this is brighter today
for three reasons:
Pent-up spending could even be essential (non-discretionary)
This refers to spend that corporates had put off in difficult times and have
released now, such as upgrading existing systems or upgrading SAP
modules. Hence, some part of pent-up relates to core IT spending of clients.
To the extent that the released pent-up demand in FY11 relates to essential
or non-discretionary IT spend, we see less uncertainty surrounding that
should the macro worsen in CY12.
Developmental spending relating to structural change of industries is
less discretionary
Nowhere do we see this more clearly than in financial services wherein the
next wave of spending encompassing mobile payment systems, integrating
the private could into legacy IT and regulation relate to developmental
spending of an essential/non-discretionary nature.
Some pent-up spending once initiated may continue regardless
Sometimes, the cost of inaction/deferral after an initial investment already
made could be so high that clients will go through with the program
regardless. For example, funding a business intelligence solution may be
termed discretionary spending but once started the arguments against
discontinuing/deferring it may prevail and it may be prudent to sustain it
from a NPV perspective.
Also, some discretionary projects will necessarily lead to follow-on else the
investment already done will be rendered unproductive and wasted. For
example, implementing virtualization of data-centers is only a starting step
towards making applications that use resources (housed in virtualized data
centers) more efficient and standardized. In other words, it is not necessarily
true that pent-up spending is more readily turned off in times of economic
uncertainty. Pent-up spending does have its beneficial follow-on
consequences.
The nature of demand is changing but the gains are
accruing selectively to vendors
Newer themes and sub-verticals are coming to the fore
It strikes us that despite revenue contribution from M&A integration in M&A
tapering off in financial services, the BFSI juggernaut still rolls on Indian IT has
impressively kept pace in servicing the growing needs of banks tapping into
new/recent areas such as analytics, mobile banking, data management/reporting,
transformation. Equally impressively, these capabilities are being rolled out across
sub-verticals within a vertical (say in retail banking, commercial banking, asset
management, investment banking in BFS) and within insurance covering property,
life, casualty, reinsurance etc. This could help compensate for the petering out of
M&A integration projects as the implementation phase comes to a closure.
However, as companies in the US sit on record cash levels and seek to strengthen
their competitive positioning , M&A could be more broad-based and Indian IT
companies could develop a specialized M&A integration practice to roll out beyond
BFSI (see box titled : A typical M&A integration project in action).
Case study: A typical M&A integration project in action
We had a conversation with a technology integration expert from a Tier-1 technology
company. The chief conclusion is that most M&A integration projects are typically
over in one year with maximum ramp-up in 4-6 months (quarter 2) leading to lowervalue maintenance down the line. However, Infosys believes that entry into clients
through M&A integration allows admission to other client programs and a broader
footprint of services, which may not have been available to it otherwise.
(a) Typically, timelines for technology integration are less than 6-8 months, in
over 90% of the cases over by one year. This is inclusive of an initial
consulting period of 1-2 months which looks at aspects such as organization
design, portfolio optimization (portfolio rationalization and consolidation)
followed by system redesign and integration which tends to last for 4-6 months.
This is in line with extremely aggressive time-wise mandates coming from the
very top management to achieve technology and business integration.
(b) Size of significant post merger integration (PMI) deals can vary from USD
10-25 mn while it lasts. However, we point out again, this is only for the larger
deals. This could be in cases, where (a) the Indian vendor (e.g. TCS) works only
with the acquirer and gets the acquired company into its fold post merger as a
new client and (b) complete overhauling of systems of either the acquirer or
acquired or both (as opposed to merely patching or integrating systems/data
bases/technology platforms). So, assuming that TCS or others bags two-three
such deals a quarter, the annualized run rate of all such deals in a year could be
about USD 100-150 mn (on an averaged-out incremental basis), enough to move
the needle on revenues in Year 1 (FY12) but also sizable enough to disrupt
growth in Year 2 (FY13 over FY12) if this does not repeat to anywhere near this
extent. However, our expert also said that there are many smaller M&A deals
than USD 25 mn in size as well in other verticals that his company is
prospecting.
(c) The follow-on after immediate integration opportunity will be determined
by maintenance and continuous improvement-based revenues but this tends
to be much smaller. The vendor can hope to capture downstream maintenance
of integrated systems after its implementation. But maintenance revenues tend to
be smaller than initial PMI-related revenues. Hence, it is natural to expect a fall
in revenue trajectory over time of deals initiated by M&A integration
opportunities unless the vendor effectively finds more business elsewhere in the
combined acquirer-acquired entity.
(d) The name of the game moves to spinning out M&A teams to seek out
opportunities beyond the financial service sector and prepare aggressively for
M&A 2.0
Secular, structural changes are happening across industries
The picture is similar in other verticals as well. Infosys has shown examples of this
in retail where multi-channel commerce (~10% of Infosys’ retail revenues), packageled process simplification and customized solutions for digital marketing are hitting
full gear and comprising an increasing mix of Infosys' revenues in this vertical. This
represents an added addressable opportunity playing out for the Tier-1 players away
from the traditional back-office/mid-office to the front office (online commerce for
example).
Within telecom, a vertical that has been staid for the past two years, action picks up
in the emerging markets (TCS has leveraged this) as telecom equipment vendors seek
enhanced growth outside of their core, traditional markets. The wireless segment –
traditional new to offshore outsourcing, is beginning to see its benefits and if this
sub-segment takes off, it should to some extent help compensate for the sluggishness
seen in the wireline service provider segment.
In manufacturing, integration of supply chains and implementation of optimization of
inventory, lead-times are examples of transformation-led work that tier-1 companies
have not addressed even as recently as three years back (pre-crisis). As an example
of structural changes in the troubled BFSI industry still throwing up newer
opportunities/imperatives in technology spending, refer to the case study - ‘New
realities in BFSI give rise to new priorities'.
Case study: New realities in BFSI give rise to new priorities
A large US-based investment bank has reconciled itself to stalling growth in the US,
which currently drives nearly half of its global revenues. Stricter norms around
proprietary trading and mortgage-based lending have led to cutbacks in investments
on proprietary trading/mortgage platforms and on subsequent implementations and
mortgage-based trading platforms. However, new realities have taken over. The bank
is focused on using “consumerization of technology” themes to improve customercentricity. Towards this, it is rapidly building out mobile payments systems. It is
enhancing its data-mining capabilities, working on deriving greater actionable
insights from both structured data (data thrown through queries and programs) and
unstructured data (data generated from blogs, wikis, social networking sites etc.).
Towards this end, it is enhancing its knowledge management system using analytic
tools/technologies from best-of-class technology vendors (both software and service
vendors).
Also present is the inevitable emerging market agenda – a recurring theme in many
(if not most) global enterprises. The bank is channeling the cost savings realized
from its variablization of cost program in the US to drive its strategies around
globalization. Technology initiatives related to globalization include system
integration, new infrastructure build-out, streamlining channels of communication
and information flow by integrating dispersed systems for a holistic view and
tentatively rolling out banking on demand models in new markets using cloud
computing.
The consequence of this re-alignment of priorities is that total IT spending still grows
at a normalized pace of low single digit per annum despite business pressures in the
major (developed) markets.
Europe (Non-UK) is a tough market but patience can afford gratifying gains
longer term
Notably, Cognizant believes that penetration of the offshoring applications
infrastructure model in Europe does not exceed 10% but working on this is
hard work. Nowhere is localization required to such a fine degree to succeed as in
Continental Europe. Not only is penetration non ADM-led (over 40% of Infosys’
revenues in Europe is package-implementation/consulting/transformation-led which
is 1.5x the company average) but the nature of assignments entail a much higher
proportion of local onsite resources who are specific to that market. In keeping with
the dynamics of the market here, Infosys has invested in local country structures in
Germany/France and ramping up presence.
Sales cycles in Continental Europe are longer; deals come from outside BFSI such as
energy & utilities, manufacturing and retail given the presence of G-500/G-1000
(Global List) from such verticals in these markets. Infosys tells us that Germany and
France have more than twice the number of Global 1000 companies as UK and the
total IT spending is about 1.7 times that of UK. Much greater flexibility is needed to
invest in local delivery centres to service this geography (which includes local shared
services as well such as local marketing, finance, HR, etc.). IBM in Germany is
culturally and nationally very different from IBM in the US.
But the gains that accrue long-term can be immense and differentiated, in our view,
because of the very nature of the market. Immense because Continental Europe is
beginning to wake up to the advantages of outsourcing, vendor consolidation is
underway (e.g. at BMW, Volkswagen) and those vendors are willing to customize,
adapt and be patient stand to benefit. Differentiated because traditional ADM is
perhaps not the way to make inroads but rather higher-value transformation-based
services afford the better gateway, which is capability confined largely to Tier-1
players.
The numbers are beginning to speak for the efforts: since FY08, the beginning of the
downturn, Infosys' revenues from non-UK have increased to 50% of revenues today,
significantly up from 32% as of FY08. Germany, in particular, has shaped up very
well for Infosys as a market responding well to local country structures
Another source of market share gains opens up with the rebid market. The rebid
market does not draw on additional IT spending but is simply a case of market share
shifts as traditional, large outsourcing contracts of global incumbent system
integrators come up for renewal/rebid in CY10-12. Opportunity size of such deals
estimated by third-party consultants (such as TPI) are USD 70-100 billion but we
note that even if such large deals are disaggregated, the realistic addressable market
for best-of-breed offshore vendors is likely much smaller as such deals encompass
hardware, software, infrastructure and other types of bundled infrastructure - areas
that tier-1 Indian IT companies avoid. We estimate that about 15-20% of this is
addressable.
As per our estimate, as a result of all of the above, the top-tier companies have built
new/recent revenue streams that may account for about 10% of the revenues on an
incremental basis – no small achievement given their base(s).
To sum up, Tier-1 companies are being called to the table on opportunities
whose nature is changing. It is selective and is accruing to those whose account
management capabilities are well-aligned to their delivery capabilities. We
believe TCS leads in capturing the early share of these incremental
opportunities.
Playing multiple high potential themes that present
themselves in today’s technology-rich environment
Nowhere in the past has there been such a happy multiplicity of themes cutting
across horizontals, verticals and technologies as today. Some such themes include
analytics, mobility, digitization, devices, healthcare, specific opportunities
customized to the needs of specific markets (emerging markets for instance).
Tackling some of these themes is made possible by new technologies revolving
around the cloud, internet collaboration (such as Web 2.0), mobile networks etc.
As an example, in healthcare, we see two significant opportunity forces at
play: (a) conversion to ICD 10, the new format/ framework for coding and
data capture in collating and documenting diseases/health hazards, and (b)
integrating the provider (hospital) into the payer equation as well.
The “digitization" theme gains importance in the media and financial
services industries. Digitization of information lends flexibility to the
manner in which information can be used to provide intelligence and
solutions.
To be sure, themes, by themselves, may not necessarily represent huge market
opportunities unless they are over-arching (example, an analytics framework
rolled out across multiple verticals) or a technology that can spawn a new
practice (e.g. cloud computing). However, like point solutions, they could serve
as effective door-openers and help build stickiness in client relationships.
The full-services model has been the overarching theme thus far for Tier-1 Indian IT
companies. Today, they are identifying and operationalizing themes that cut across
verticals
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Part 1 of this series focused on price and valuation action during and immediately
following the 2008 recession and lessons for investors. In this edition (Part 2), we
investigate how: (a) IT services spending has behaved post-2008; and (b) Tier-1
Indian IT companies’ business models have evolved to manage volatilities and
complexities in IT spending since 2008? On both counts, we find a more assuring
picture.
One, we think IT-Services spending post 2008 has been largely disciplined
since coming off the previous financial crisis. Since 2008, US IT-Services
spending as % of US GDP has moderated signifying that excesses have not
been built in the system. Client firms, in general, have spent thoughtfully in the
last three years. Within the IT-Services spectrum, offshore IT services tend to
be least cyclical and are a much greater play on operations/IT than capex.
Two, there tends to be a period of client adjustment, typically spanning 2-3
quarters. Low global growth per se is not negative once the adjustment to the
new lower normal is made. Corporates (client firms), despite their better health
this time around, could take 2-3 quarters more to further adjust their business
priorities and calibrate (even trim) their IT spending if needed. Admittedly, this
period could be rocky for Indian IT but this readjustment phase paves the way
for acceleration of durable, sticky market-share gains for select vendors starting
mid-FY13. As per past data, crises tend to accelerate market share shifts in favor
of select players. Vendor consolidation is but one contributory factor to this.
Three, we see both push and pull factors at play. “Push” refers to Indian IT
selling its existing value proposition to first time outsourcers (FTOs) and newer
verticals in times of economic turmoil such as today. For example, Cognizant
believes that despite huge economic uncertainty in Europe, the offshore
outsourcing proposition has achieved penetration of just 10% there. “Pull”
relates to Indian IT enhancing its value proposition through forays into cloud
computing, analytics, mobility, more sophisticated methods of complex program
management, productivity-based pricing etc. Much of the appeal associated with
the Pull factor was developed/solidified in the past three years. The “pull”
factor does not get due recognition from investors, in our view. The silver lining
to the Lehman crisis was that players such as TCS/Cognizant have expanded
addressable market since then thanks to both the push and pull factors.
Four, we acknowledge the argument that corporates sitting on record cash and
profitability is not a wholly persuasive one (why would clients invest if demand
for their products/services is marked down?). Yet, we see another silver lining
here – clients will rush in with much better capacity than ever before to invest if
there is the slightest hint of stability or uptick in the macro-environment. Unless,
of course, a deep external shock intervenes (ala Lehman collapse).
Finally, valuations are getting to be supportive though not fully there yet.
Another 10% decline in prices of TCS/Infosys will essentially mean they have
just 2-3 years of 15% growth before they settle down to a perpetual growth of
5%, a conservative implication, in our view. We are buyers for at least 15-
20% returns over the next 9-12 months in select stocks. We back players
such as TCS (OW) that are best positioned to win durable market share gains.
We are slightly more constructive on Infosys (Neutral) than in the past due to its
much moderated valuations (more than 1 std. deviation below 5 yr. median P/E).
IT-Services spending post 2008 has been
thoughtful and disciplined
US IT-Services spending has moved as % of US GDP and
US corporate profits respectively since 2008 (the last financial crisis). IT-Services
spending as % of both GDP and corporate profits have moderated which suggests
that IT-Services spending post 2008 has been disciplined and thoughtful. During this
period (2009-present), Indian IT continued to handsomely gain market share which
suggests that the sector plays well to thoughtful, disciplined spending patterns of
clients.
Also, by implication, the room for enterprises to cut IT budgets is less this time
around than before (in other words, there is less excess to work off).
A crisis tends to accelerate durable
market-share gains for select players
poised to take advantage
Market-share gains in Indian IT tend to be durable, sticky and those who grab
them position themselves well for the next 2-3 years. The 2001-02 tech downturn
saw the Big 4 in Indian IT (TCS/Infosys/Wipro/Cognizant/HCLT) break away from
the pack. The 2008 financial crisis saw Wipro fall behind and Cognizant surge ahead.
Also, concurrently Accenture started playing aggressively using their India model
with much greater effectiveness emerging with share gains from 2008. Today, the
situation is no different. This downturn will likely create further separation among
this group of 3-4 players. In this context, we believe that TCS is positioning itself
well for the market share gains.
It remains to be seen how strongly Infosys (Neutral) emerges from the current
slowdown under the new leadership. Our view is that momentum once lost is
not easy to reclaim. The new Infosys management led by Mr. Shibu Lal has its
task cut out.
Market share gains for Indian IT accelerate during downturns as clients turn
even more disciplined in their spending. In terms of market share gains, Indian IT
companies gained market share by ~0.25% in the 1999-2001 period. However,
slowdown in 2001-02 led to increased focus on offshoring, and Indian IT gained
market share by ~0.5-0.7% every year in the 2002-2007 period. The market share
gains continue to accelerate after the CY08 downturn and Indian IT companies’
penetration level in global IT services spending has increased about 130 bps over the
last two years. We believe the current slowdown will further accelerate this market
share gain trend, due to the following:
1. Downturns force customers to cut costs/restructure business processes and
become more disciplined, thus leading them to look more closely at Indian
IT companies/offshore to cut those costs/restructure business processes.
This is a 2-3 quarter period of adjustment to overcome the initial
uncertainty.
2. Indian IT companies have increased the portfolio of their service offerings
over the past few years, allowing them to serve a much larger proportion of
IT budgets of customers.
3. Indian IT companies have grown bigger, allowing them to bid for larger
deals and thereby increasing the addressable market for Indian IT.
4. Indian IT companies have increased domain expertise in several industries.
In a nutshell, the addressable market for Indian IT continues to increase impressively,
and their relative positioning becomes more attractive over time. As a result, we
expect market share gains to further accelerate in case of a downturn.
How severe are issues on margins and
pricing during the current weakness?
The margin question –levers still exist to absorb pricing
declines in FY12E
Indian IT companies saw pricing pressure in the 2001-2003 downturn that led to
margin declines. As a result, EBIT and EPS growth lagged revenue growth.
Concerns have been raised about a similar compression in the current downturn. We
believe there are two facets of the margin issue:
1. Customers under stress could ask for price declines. This is a likely
scenario, in our view, and it is important to see how much cushion Indian
companies have to absorb margins.
2. Competition could cut prices and therefore require Indian IT players to cut
prices. We think this scenario is highly unlikely.
Overall, we believe Indian IT companies can largely sustain margins given a buffer
for FY12E. Continued pressures would, however, lead to a downward bias to our
estimates for FY12. Admittedly, the scope for SG&A rationalization and onsite-tooffshore transition is less this time around versus CY08/09, so the levers to manage
margins this time around (except growth itself) are fewer and/or less potent.
How meaningful can price declines get? Not a great worry
unless troubled customers force the issue much more
Pricing declines likely to be modest
It is conceivable that customers would ask for pricing declines in the weak economic
environment. In the last economic downturn, prices fell sharply for most Indian IT
players. However, we believe that extent of pricing declines could be lower than last
time as:
1. Post 2008, Indian IT companies have had tempered pricing increase. Most
price increases stemmed from COLA increases (cost of living adjustments)
rather than out-of-step increases.
2. A number of large customers are willing to offset pricing declines with
higher volumes and higher offshore volumes. In many cases, this is done by
converting T&M contracts to fixed price contracts. While this does pass on
execution risk to vendors, it helps Indian IT companies maintain margins
despite a lower price point.
Ways to offset price decline
We believe Indian IT companies have several levers to offset price declines.
1. Utilization for Indian IT companies is significantly below peak levels
achieved in 2001-2003 (except for TCS).
2. Recent rupee depreciation should help significantly in creating a margin
cushion for FY12E. We are assuming Rs44/US$ in our forecasts.
3. A good portion of current salaries (~15-20%) are variable, and reducing
these in the downturn could lead to cost cutting of 200-300bp.
We believe Indian IT companies could get strong tailwinds through these measures --
even to the extent of 200bp - that could absorb most of the pricing pressures.
Business model analysis: Select players
better placed than ever before
“Push” and “Pull” factors at play
“Push” refers to Indian IT selling its existing value proposition to first time
outsourcers (FTOs) and newer verticals in times of economic turmoil such as today.
For example, Cognizant believes that despite huge economic uncertainty in Europe,
the offshore outsourcing proposition has achieved penetration of just 10% there.
“Pull” relates to Indian IT enhancing its value proposition through forays into cloud
computing, analytics, mobility, more sophisticated methods of complex program
management, productivity-based pricing etc. Much of the appeal associated with the
Pull factor was developed/solidified in the past three years. The “pull” factor is
stronger than before and this does not always get due recognition from investors, in
our view. The silver lining to the Lehman crisis was that Tier-1 stocks such as
TCS/Cognizant have expanded addressable market since 2008 thanks to both the
push and pull factors. We explore both the “Push”.
Development spending is sustainable to a fair degree;
discretionary spending does not tail off at once
As clients look beyond cost-cutting and are engaging in IT spends to help drive
revenues (revenue-enhancement related IT initiatives), not surprisingly development
and discretionary spending has made strong come-back in the last 4-6 quarters
Will this sustain? We believe that the outlook on sustenance of this is brighter today
for three reasons:
Pent-up spending could even be essential (non-discretionary)
This refers to spend that corporates had put off in difficult times and have
released now, such as upgrading existing systems or upgrading SAP
modules. Hence, some part of pent-up relates to core IT spending of clients.
To the extent that the released pent-up demand in FY11 relates to essential
or non-discretionary IT spend, we see less uncertainty surrounding that
should the macro worsen in CY12.
Developmental spending relating to structural change of industries is
less discretionary
Nowhere do we see this more clearly than in financial services wherein the
next wave of spending encompassing mobile payment systems, integrating
the private could into legacy IT and regulation relate to developmental
spending of an essential/non-discretionary nature.
Some pent-up spending once initiated may continue regardless
Sometimes, the cost of inaction/deferral after an initial investment already
made could be so high that clients will go through with the program
regardless. For example, funding a business intelligence solution may be
termed discretionary spending but once started the arguments against
discontinuing/deferring it may prevail and it may be prudent to sustain it
from a NPV perspective.
Also, some discretionary projects will necessarily lead to follow-on else the
investment already done will be rendered unproductive and wasted. For
example, implementing virtualization of data-centers is only a starting step
towards making applications that use resources (housed in virtualized data
centers) more efficient and standardized. In other words, it is not necessarily
true that pent-up spending is more readily turned off in times of economic
uncertainty. Pent-up spending does have its beneficial follow-on
consequences.
The nature of demand is changing but the gains are
accruing selectively to vendors
Newer themes and sub-verticals are coming to the fore
It strikes us that despite revenue contribution from M&A integration in M&A
tapering off in financial services, the BFSI juggernaut still rolls on Indian IT has
impressively kept pace in servicing the growing needs of banks tapping into
new/recent areas such as analytics, mobile banking, data management/reporting,
transformation. Equally impressively, these capabilities are being rolled out across
sub-verticals within a vertical (say in retail banking, commercial banking, asset
management, investment banking in BFS) and within insurance covering property,
life, casualty, reinsurance etc. This could help compensate for the petering out of
M&A integration projects as the implementation phase comes to a closure.
However, as companies in the US sit on record cash levels and seek to strengthen
their competitive positioning , M&A could be more broad-based and Indian IT
companies could develop a specialized M&A integration practice to roll out beyond
BFSI (see box titled : A typical M&A integration project in action).
Case study: A typical M&A integration project in action
We had a conversation with a technology integration expert from a Tier-1 technology
company. The chief conclusion is that most M&A integration projects are typically
over in one year with maximum ramp-up in 4-6 months (quarter 2) leading to lowervalue maintenance down the line. However, Infosys believes that entry into clients
through M&A integration allows admission to other client programs and a broader
footprint of services, which may not have been available to it otherwise.
(a) Typically, timelines for technology integration are less than 6-8 months, in
over 90% of the cases over by one year. This is inclusive of an initial
consulting period of 1-2 months which looks at aspects such as organization
design, portfolio optimization (portfolio rationalization and consolidation)
followed by system redesign and integration which tends to last for 4-6 months.
This is in line with extremely aggressive time-wise mandates coming from the
very top management to achieve technology and business integration.
(b) Size of significant post merger integration (PMI) deals can vary from USD
10-25 mn while it lasts. However, we point out again, this is only for the larger
deals. This could be in cases, where (a) the Indian vendor (e.g. TCS) works only
with the acquirer and gets the acquired company into its fold post merger as a
new client and (b) complete overhauling of systems of either the acquirer or
acquired or both (as opposed to merely patching or integrating systems/data
bases/technology platforms). So, assuming that TCS or others bags two-three
such deals a quarter, the annualized run rate of all such deals in a year could be
about USD 100-150 mn (on an averaged-out incremental basis), enough to move
the needle on revenues in Year 1 (FY12) but also sizable enough to disrupt
growth in Year 2 (FY13 over FY12) if this does not repeat to anywhere near this
extent. However, our expert also said that there are many smaller M&A deals
than USD 25 mn in size as well in other verticals that his company is
prospecting.
(c) The follow-on after immediate integration opportunity will be determined
by maintenance and continuous improvement-based revenues but this tends
to be much smaller. The vendor can hope to capture downstream maintenance
of integrated systems after its implementation. But maintenance revenues tend to
be smaller than initial PMI-related revenues. Hence, it is natural to expect a fall
in revenue trajectory over time of deals initiated by M&A integration
opportunities unless the vendor effectively finds more business elsewhere in the
combined acquirer-acquired entity.
(d) The name of the game moves to spinning out M&A teams to seek out
opportunities beyond the financial service sector and prepare aggressively for
M&A 2.0
Secular, structural changes are happening across industries
The picture is similar in other verticals as well. Infosys has shown examples of this
in retail where multi-channel commerce (~10% of Infosys’ retail revenues), packageled process simplification and customized solutions for digital marketing are hitting
full gear and comprising an increasing mix of Infosys' revenues in this vertical. This
represents an added addressable opportunity playing out for the Tier-1 players away
from the traditional back-office/mid-office to the front office (online commerce for
example).
Within telecom, a vertical that has been staid for the past two years, action picks up
in the emerging markets (TCS has leveraged this) as telecom equipment vendors seek
enhanced growth outside of their core, traditional markets. The wireless segment –
traditional new to offshore outsourcing, is beginning to see its benefits and if this
sub-segment takes off, it should to some extent help compensate for the sluggishness
seen in the wireline service provider segment.
In manufacturing, integration of supply chains and implementation of optimization of
inventory, lead-times are examples of transformation-led work that tier-1 companies
have not addressed even as recently as three years back (pre-crisis). As an example
of structural changes in the troubled BFSI industry still throwing up newer
opportunities/imperatives in technology spending, refer to the case study - ‘New
realities in BFSI give rise to new priorities'.
Case study: New realities in BFSI give rise to new priorities
A large US-based investment bank has reconciled itself to stalling growth in the US,
which currently drives nearly half of its global revenues. Stricter norms around
proprietary trading and mortgage-based lending have led to cutbacks in investments
on proprietary trading/mortgage platforms and on subsequent implementations and
mortgage-based trading platforms. However, new realities have taken over. The bank
is focused on using “consumerization of technology” themes to improve customercentricity. Towards this, it is rapidly building out mobile payments systems. It is
enhancing its data-mining capabilities, working on deriving greater actionable
insights from both structured data (data thrown through queries and programs) and
unstructured data (data generated from blogs, wikis, social networking sites etc.).
Towards this end, it is enhancing its knowledge management system using analytic
tools/technologies from best-of-class technology vendors (both software and service
vendors).
Also present is the inevitable emerging market agenda – a recurring theme in many
(if not most) global enterprises. The bank is channeling the cost savings realized
from its variablization of cost program in the US to drive its strategies around
globalization. Technology initiatives related to globalization include system
integration, new infrastructure build-out, streamlining channels of communication
and information flow by integrating dispersed systems for a holistic view and
tentatively rolling out banking on demand models in new markets using cloud
computing.
The consequence of this re-alignment of priorities is that total IT spending still grows
at a normalized pace of low single digit per annum despite business pressures in the
major (developed) markets.
Europe (Non-UK) is a tough market but patience can afford gratifying gains
longer term
Notably, Cognizant believes that penetration of the offshoring applications
infrastructure model in Europe does not exceed 10% but working on this is
hard work. Nowhere is localization required to such a fine degree to succeed as in
Continental Europe. Not only is penetration non ADM-led (over 40% of Infosys’
revenues in Europe is package-implementation/consulting/transformation-led which
is 1.5x the company average) but the nature of assignments entail a much higher
proportion of local onsite resources who are specific to that market. In keeping with
the dynamics of the market here, Infosys has invested in local country structures in
Germany/France and ramping up presence.
Sales cycles in Continental Europe are longer; deals come from outside BFSI such as
energy & utilities, manufacturing and retail given the presence of G-500/G-1000
(Global List) from such verticals in these markets. Infosys tells us that Germany and
France have more than twice the number of Global 1000 companies as UK and the
total IT spending is about 1.7 times that of UK. Much greater flexibility is needed to
invest in local delivery centres to service this geography (which includes local shared
services as well such as local marketing, finance, HR, etc.). IBM in Germany is
culturally and nationally very different from IBM in the US.
But the gains that accrue long-term can be immense and differentiated, in our view,
because of the very nature of the market. Immense because Continental Europe is
beginning to wake up to the advantages of outsourcing, vendor consolidation is
underway (e.g. at BMW, Volkswagen) and those vendors are willing to customize,
adapt and be patient stand to benefit. Differentiated because traditional ADM is
perhaps not the way to make inroads but rather higher-value transformation-based
services afford the better gateway, which is capability confined largely to Tier-1
players.
The numbers are beginning to speak for the efforts: since FY08, the beginning of the
downturn, Infosys' revenues from non-UK have increased to 50% of revenues today,
significantly up from 32% as of FY08. Germany, in particular, has shaped up very
well for Infosys as a market responding well to local country structures
Another source of market share gains opens up with the rebid market. The rebid
market does not draw on additional IT spending but is simply a case of market share
shifts as traditional, large outsourcing contracts of global incumbent system
integrators come up for renewal/rebid in CY10-12. Opportunity size of such deals
estimated by third-party consultants (such as TPI) are USD 70-100 billion but we
note that even if such large deals are disaggregated, the realistic addressable market
for best-of-breed offshore vendors is likely much smaller as such deals encompass
hardware, software, infrastructure and other types of bundled infrastructure - areas
that tier-1 Indian IT companies avoid. We estimate that about 15-20% of this is
addressable.
As per our estimate, as a result of all of the above, the top-tier companies have built
new/recent revenue streams that may account for about 10% of the revenues on an
incremental basis – no small achievement given their base(s).
To sum up, Tier-1 companies are being called to the table on opportunities
whose nature is changing. It is selective and is accruing to those whose account
management capabilities are well-aligned to their delivery capabilities. We
believe TCS leads in capturing the early share of these incremental
opportunities.
Playing multiple high potential themes that present
themselves in today’s technology-rich environment
Nowhere in the past has there been such a happy multiplicity of themes cutting
across horizontals, verticals and technologies as today. Some such themes include
analytics, mobility, digitization, devices, healthcare, specific opportunities
customized to the needs of specific markets (emerging markets for instance).
Tackling some of these themes is made possible by new technologies revolving
around the cloud, internet collaboration (such as Web 2.0), mobile networks etc.
As an example, in healthcare, we see two significant opportunity forces at
play: (a) conversion to ICD 10, the new format/ framework for coding and
data capture in collating and documenting diseases/health hazards, and (b)
integrating the provider (hospital) into the payer equation as well.
The “digitization" theme gains importance in the media and financial
services industries. Digitization of information lends flexibility to the
manner in which information can be used to provide intelligence and
solutions.
To be sure, themes, by themselves, may not necessarily represent huge market
opportunities unless they are over-arching (example, an analytics framework
rolled out across multiple verticals) or a technology that can spawn a new
practice (e.g. cloud computing). However, like point solutions, they could serve
as effective door-openers and help build stickiness in client relationships.
The full-services model has been the overarching theme thus far for Tier-1 Indian IT
companies. Today, they are identifying and operationalizing themes that cut across
verticals
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