2 Stock Picks in IT Services

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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Coffina: We've been tracking a few important themes lately. For example, vendor consolidation, the shift to global delivery, as well as the rise of SMAC Services--or social, mobile, analytics, and cloud--which of these trends do you see as the most important for IT services?

Lange: We think all of them together combined will drive IT services spending and IT service vendors' behavior for the next five to 10 years. In terms of consolidation, we're seeing that the vendors themselves consolidate. That's really based upon the fact that the clients themselves are consolidating the guys who provide them services. That's driven largely by the customer wanting to reduce costs and also increase business agility.

What that leads to is this growth in a global delivery network. They want a vendor who can provide end-to-end services, 24/7. So, what this global delivery network really means for the vendor as well is that they're going out into other countries--say, India or Southeast Asia--and hiring tens of thousands of employees to provide IT outsourcing, business-process outsourcing. It's very important. You can lower your costs; you can provide better service provision around the clock.

So, we think both consolidation and global delivery are going to be driving a lot of vendor behavior. Then, I think one of the other very important parts of this is SMAC--or, as you say, social, mobile, analytics, and cloud. It is a key topic in the industry at the moment, given the transformational nature of what's going on there.

I think if you look at IDC, they say that by 2020 80% of IT spending is going to be on SMAC-related services. So, obviously, it's going to be a huge growth driver, and we've seen many of these vendors at the moment starting to position their portfolios--M&A, R&D--to really build out the capabilities at the moment.

Coffina: What are your top picks in the industry?

Lange: So, top picks at the moment. What we actually provided recently was a vendor-positioning framework around the IT services industry. What that really looks at are five key points in order to differentiate these top-flight providers. That's one thing I must say: At Morningstar, we cover the top-flight guys, and sometimes it can be a little bit hard to distinguish what's really going on between these guys.

With this framework, we look at the client relationships and the brand that the business has built, industry expertise, we look at their financial strength, the IP, and their global delivery network capabilities. Putting all of the companies through this assessment, we come out with Accenture and Cognizant (CTSH) as being the two best companies that we cover here.

From a business-quality perspective, we think Accenture is the highest-quality name in the IT services industry. It ticks all of the boxes across our framework; it has a strong, competitive position there. I'd note that it's the only wide-moat stock in the IT services industry, and it is trading at 3 stars at the moment and close to our $81 fair value.

Cognizant, on the other hand, is a narrow-moat stock. It's trading in 4-star territory at the moment. It's roughly at a 20% discount to our fair value, and it is providing the most upside within the industry. So, we think Cognizant has a really nice blend of having both onshore presence and offshore presence, and we think they are a well-positioned company.

Coffina: Thanks for joining me, Andrew.

Lange: Thank you.

Coffina: In conclusion, global clients are increasingly outsourcing their IT services to the highest-quality firms--those who can deliver end-to-end services, global delivery capabilities, and technological expertise that a lot of companies can't match in-house. Our top picks are Accenture, which we think is the only wide-moat IT services company, and Cognizant Technology Solutions, which is a little bit more of an up-and-comer but is trading at a reasonable valuation and has relatively robust growth prospects.

For Morningstar StockInvestor, I'm Matt Coffina. Thanks for joining us.

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