(By Swami Shanmugasundaram)Its sheer size and fragmentation make IT
services one of the more dynamic--and more misunderstood--industries in
the technology sector. We believe it is an industry that warrants
investors' attention, given its defensive nature, solid growth prospects
and profit margins offered to the top competitors, and relatively high
concentration of economic moats.
Before delving deep into economic moats, it is important to
understand the size, general characteristics, and different subsectors
that make up the IT services industry. The key differentiator among
services firms is the sectors in which they participate. Each sector has
different characteristics that define the skill sets that companies
need to build in order to earn a moat around their operations. These
characteristics also explain the relative ease with which service
providers can straddle the different sectors. For example, while it is
easy for a consulting service provider to expand its reach and move into
outsourcing, the reverse transition is very challenging.
A Fragmented but Resilient Industry
IT services is a large but fragmented industry. The amorphous $800
billion-plus market covers a broad spectrum of offerings ranging from
high-end IT consulting to low-end business process outsourcing. The
market is fragmented, with few large players and numerous small to
midsize competitors. According to market research firm Gartner, the top
10 service providers account for about 27% of the market while the top
20 have 38% share. The industry's inherent characteristics--including
low barriers to entry, a wide variety of market segments, and large
numbers of buyer groups--have made it difficult for a few players to
dominate the market.
The IT services industry is defensive with stable growth prospects.
It is resilient because recurring revenue streams tied to clients'
nondiscretionary operating budgets represent a higher component of the
overall services revenue mix. This was evident during the 2009-10
recession, when most of the top-tier players reported flat or positive
revenue growth after adjusting for currency effects. Gartner estimates
that the total market for services will grow at a compound annual rate
of 4.6%, from an estimated $844 billion in 2011 to an estimated $1,058
billion in 2016.
The industry can be broadly broken down into four buckets based on
the type of services rendered: consulting, system integration and
application development, IT outsourcing, and business process
outsourcing. Consulting and SI are more project-based businesses, while
IT outsourcing and BPO are managed through long-term contracts (five to
seven years on average). IT outsourcing and BPO services could be
characterized as resilient, as they have a recurring revenue stream
based on their long-term contracts. Also, these services depend on the
client's less discretionary operating budget and are typically the last
ones to be cut when companies rein in expenses. On the other hand,
consulting and SI projects tend to rely on clients' discretionary
spending, making them susceptible to capital budget cuts during economic
downturns.
Consulting involves advising clients on how to align their IT
strategy with the overall business strategy. This includes helping
clients define their IT roadmap, enterprise-level system architecture,
and so on. System integration mostly involves the design and
implementation of enterprise software and its integration with the
client's existing systems and processes. Consulting/SI-led solutions are
typically the tip of the iceberg that, when done right, will normally
lead to recurring downstream maintenance revenue.
Application development work includes projects to develop new
customized applications, enhance existing applications, or transition
applications to new platforms. Application management, which could be
considered an offshoot of application development, involves supporting
existing applications, including fixing issues and handling minor
updates. Offshore players are seen as strong competitors in application
development and management.
Business process outsourcing involves the contracting of the
operations and responsibilities of business functions that are IT
enabled to a third-party service provider. BPO is typically categorized
into either back-office outsourcing (finance and accounting or human
resources) or front-office outsourcing (customer-related services such
as contact center services). Customer management is the largest BPO
segment and consists primarily of call center-based customer service
support. Phone-based support accounts for a significant part of the
customer service support. Examples of human resources outsourcing
include transaction processing such as payroll or benefits
administration, staffing, training, and recruiting.
Factors That Help Service Providers Earn Their Moat
At Morningstar, we believe economic moats stem from five sources: cost
advantages, intangible assets, switching costs, network effects, and
efficient scale. Of these, cost advantages, switching costs, and
intangible assets are the key sources of competitive advantage for IT
service firms as they attempt to carve a moat around their operations.
Given the different characteristics of various service offerings, we
evaluate the moatiness of each of the services individually and assign a
moat to a service provider based on its services revenue mix.
Source of Moats
Source: Morningstar
Consulting and SI firms earn their moats from intangible assets such
as reputation, track record, and client relationships. Consulting and SI
are project-oriented assignments that are mostly short-term, ranging
from a few weeks to few months. Given the size and duration of these
assignments, switching costs aren't really a factor. Intangible assets
like reputation, track record, and client relationships play a greater
role in winning and sustaining clients. These attributes generally carry
substantial weight in customer buying decisions, potentially acting as
entry barriers. Of the three, reputation and track record carry more
weight than relationships, in our opinion. This is one of the main
reasons offshore-based players are finding it difficult to move up the
IT services ladder. Though these companies have an excellent track
record in outsourcing, they don't have much to show off when it comes to
consulting. Despite their entrenched client relationships, these firms
have limited success in breaking the stronghold of companies such as 
Accenture(ACN), Capgemini(CAP), Deloitte, and IBM(IBM) in the consulting arena.
Customer switching costs
and cost advantages help IT outsourcing service providers protect their
turf from competitors. A typical application development and maintenance
assignment involves developing and supporting core IT solutions that
form the basic foundation of running the business, such as enterprise
resource planning systems, or business applications, such as vendor
management systems by a distributor. Given the complex nature of these
systems, firms devote a significant amount of time, effort, and money to
building and running them. When partnering with a service provider,
companies typically bundle development and maintenance contracts. On
average, these contracts run for five to seven years and, at the time of
renewal, the incumbent generally holds an advantage over competitors.
The switching costs associated with the transition are a key deterrent
that prevents companies from choosing a different partner for
development and maintenance, changing the service provider during
renewal, or taking it in-house. It takes 9-18 months to transition from
one service provider to the other, and during this period the company
has to pay both service providers. Most of the time, the additional cost
and effort outweigh the cost benefits. Thus, client attrition is very
minimal and repeat business accounts for about 97%-plus of annual
business.
Cost advantages also contribute to the moat for IT outsourcing
providers. As offshoring became mainstream, the use of global resources
to deliver services at a lower cost was considered a required delivery
mechanism. We believe that a hybrid model with onsite, offshore, and
near-shore capabilities is essential for a successful global delivery
platform. Service providers without a sizable offshore delivery network
are at a huge handicap to those that have established an offshore
presence. Traditional consulting players like IBM and Accenture were
early adopters of the offshoring model and capitalized on the strong
demand for offshore services. In contrast, other legacy firms like
CSC(CSC) and
CGI Group (
GIB) were slow to get on the bandwagon; as a result, they continue to feel the pressure from the offshoring trend.
Business process outsourcing does not provide a moat, as it is
protected by neither switching costs nor intangible assets, in our
opinion. Though BPO shares a few characteristics with IT outsourcing,
including long-term contracts, lower client renewal rates and the ease
with which IT service players penetrated the market indicate that BPO
doesn't provide a moat. In BPO, companies outsource generic corporate
functions such as finance and accounting, human resources, and
procurement-related functions. Unlike IT outsourcing, it's easier to
standardize or centralize these functions; once that happens, companies
can switch service providers with relatively lower switching costs. We
have typically seen companies switching service providers at the time of
contract renewal rather than during midcycle (to avoid contract
breakage expenses). Renewal rates in BPO average 85%, significantly less
than the 97%-plus renewal rates in the IT outsourcing business. IT
service firms entered the BPO market in an effort to capture more wallet
share of a client's selling, general, and administrative spending, and
they were able to seamlessly make the transition as BPO is generally
considered an extension of IT outsourcing. The integrated IT+BPO players
have historically performed better than pure-play BPO players, a trend
that we believe will continue.
Moats for Companies Under Coverage
Source: Morningstar
We believe Accenture and IBM are the top global players in IT
services. They are the only firms that score well on all measures.
Morningstar awards a wide moat to IBM, but that's driven more by the
strength of its hardware and software businesses. If IBM's services
business were a stand-alone entity, we think it would have a narrow
moat. In terms of pure-play service providers, Accenture leads the pack.
The company has a balanced mix of consulting and outsourcing
businesses, making it a one-stop shop. IBM and Accenture are closely
followed by Tier 1 offshore IT service providers, which include Cognizant(CTSH), Infosys(INFY), Tata Consultancy Services (TCS), and Wipro(WIT).
These firms are the pioneers of the offshore IT service industry and
have consistently delivered industry-leading growth and margin. The only
drawback of these firms is that they lack a strong consulting arm.
Though Capgemini was late to the offshoring game, it more than made up
for it by acquiring Kanbay in 2006. Since then, the company has made
significant investments to strengthen its global delivery network.
Despite their scale and full suite of offerings, we think CSC and CGI
Group don't have moats, as they score poorly in terms of global delivery
capabilities. Because of their higher cost structure, these companies
report relatively lower margins, which in turn negatively affects the
return they earn on their capital. In most cases, return on capital is
lower than the cost of capital. Capita(CPI)
is a pure-play BPO provider with limited presence in IT outsourcing
and, as we noted earlier, BPO as a stand-alone offering doesn't have a
moat.
Swami Shanmugasundaram is an equity analyst on the Technology Team.