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By Matthew Coffina, CFA and Andrew Lange | 09-23-2014 10:00 AM

2 Stock Picks in IT Services

Moaty Accenture and Cognizant are well-positioned to meet growing demand for end-to-end services and global delivery capabilities.

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Andrew Lange, who is an analyst on our technology team. We're going to talk about IT services.

Andrew, thanks for joining me.

Andrew Lange: Thanks for having me.

Coffina: To start us off, could you maybe just explain what are the major segments of the IT outsourcing market and what the major growth drivers are?

Lange: Sure. First, I think it's important to quantify what the market really looks like. The IT services industry, it's an enormous industry. It's highly fragmented. For 2013, it was estimated to be about $920 billion in revenue. But within this industry, we can broadly break it down to four parts when we exclude support services, which is more ancillary in nature. We have consulting, systems integration, IT outsourcing, and business-process outsourcing. Just for clarity, I'll take you through what each one of those means.

Consulting services is around about $95 billion in revenue, and it can range from anything such as operational initiatives to if a company would want to implement an ERP [enterprise resource planning] or CRM [customer relationship management] application further into high-level things such as "Do I have the right IT infrastructure in my business? Does it help with my current growth plans and my future growth plans?" That's a little bit of what consulting can do for you.

Moving down the chain, we can go further into systems integration; it's about $240 billion in revenue, and it can encompass everything from the integration of the CRM or the ERP system that you might get from the consulting side. So, now we're actually going to implement it into the business and that can be quite in-depth work. When you're dealing with existing IT infrastructures and building out hybrid infrastructures, it seems a bit more higher quality on the value chain. I think a good example of that would be an SAP ERP implementation. So, things like that are what sort of summarize what systems integration is.

Moving even further down, we've got IT outsourcing. It's about $290 billion in revenue, and it can exist at both application and infrastructure layers. So, we can have, at the application level, application development and maintenance. And then, being more infrastructure focused, you can have something such as data-center outsourcing. So, that's a pretty good summation of what goes on there. People tend to go for the IT outsourcing because it helps increase your business agility, reduces your costs, and a lot of these companies don't have the expertise to be able to do it or they don't really have the financial resources to be able to create this for themselves. So, that's a little bit of what's driving that.

And then, finally, we have business-process outsourcing, which is about $150 billion in revenue. It seems the lowest on the value chain in terms of commodification and those types of things. It can be anything from HR to finance and accounting to supply management and procurement. It's really all four things wrapped up.

Coffina: Which of these areas is most conducive to economic moats in your view?

Lange: At Morningstar, we think a strong consulting practice leads to a strong competitive position. We think the relationship-driven nature of consulting leads to long-dated relationships with your clients. That's proven with many of these incumbents, such as Capgemini (CAPMF) and Accenture (ACN). And it also leads to other downstream revenues--into systems integration and IT outsourcing.

So, consulting, we think, is the big one there. Nevertheless, we still think there are parts of IT outsourcing and systems integration that do offer you economic moats and high switching costs. I think the biggest takeaway from it is this: The more complex the work you're doing--the more you get into the weeds of a business--the harder it is to be able to switch you back out again. So, that really leads to what we think is the primary reason for IT service vendors to have economic moats.

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