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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 (NYSE:ACN), Capgemini (NYSE:CAP) and IBM (NYSE: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 (NYSE:CSC) and CGI Group (NYSE: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

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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 Congnizant (NASDAQ:CTSH), Infosys (NYSE:INFY), Tata Consultancy Services (TCS) and Wipro (NYSE: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.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: IT Services Abounds With Moats