CLSA: India - IT SERVICES Cloudy opportunity

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India - IT SERVICES
Cloudy opportunity
New cloud-computing segments may compromise vendors’ margins.

A sustained investment view for IT services demands a return to its “techie” roots. The new segments opening up around cloud-linked services could compromise near-term margins and return ratios for larger vendors, but promise non-linear and highly profitable growth later. Initial efforts are visible at service providers, but more urgency would be handy. With the market pricing in robust 2011 demand, our sector view is mixed with a bias towards our top two stocks Infosys and Tata Consultancy Services. See our new This is I.T. report.

A US$84bn opportunity by 2013. There is much hype about cloud computing, but the gradual pace of its real-life adoption implies opportunity rather than disruption for the IT-services sector. Like with legacy code, which still survives, the lumbering (but sustained) pace of cloud adoption should ensure that the old co-exists with the new. Vendors can step in to provide the plumbing within and around the cloud. By developing solutions around shared services, infrastructure, process platforms or virtualisation, they can venture into a new US$84bn market space, while making headway into the untapped small- and medium-business (SMB) customer segment.


Risks should be shortlived. Risks of margin dilution and higher asset intensity should be shortlived and manageable for larger vendors, as they promise non-linear revenue at up to 75% Ebitda margins. For big providers, a 60-85bp net-margin sacrifice could fund up to 15 initiatives on solution and platform development, plus amortised costs of at least one data centre (should vendors choose to own assets). Strong demand in the traditional segments in 2011 should provide large players the comfort and confidence to go ahead with these new ventures.
Talkers or doers? Vendor strategies. There is much talk and some action among vendors. Existing conservatism prevents risk-taking in the industry and will remain a hurdle. But initial efforts are visible. Tata Consultancy Services (TCS IB - Rs1,165.0 - O-PF) has used the downturn to develop four business-process outsourcing (BPO) platforms that have won 18 customers, albeit on a small scale. Infosys (INFO IB - Rs3,445.0 - BUY) has signed a potential US$20m four-year deal for its operator-centric application ecosystem, called Flypp. Incumbents are moving in too: IBM unveiled a US$360m data centre in February 2010 to provide cloud services and already has a US$650m procurement offering

Sustaining stock returns demand new investments. Demand in 2011 looks robust, but a long-term view on the sector must recognise its rapidly rising share in the real addressable market. The manpower crunch should ease for a while, but 2012 represents a real risk if demand continues unabated. IT-services companies need to sustain profitable growth beyond just a year or two to support their PE multiples. Infosys could return 7-17% annually over the next five years depending on which path it chooses. TCS and Infosys are best placed to spread investments with their large revenue bases from traditional services, which should dominate the 2011 demand surge. Wipro’s (WPRO IB - Rs490.3 - U-PF) struggles with topline growth and HCL Technologies’ (HCLT IB - Rs456.1 - U-PF) with profitability are dampeners, while incumbent behemoth Accenture is keen to shift the game away from labour costs to core technology themes.