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Evolving IT Services Market Warrants Attention

Consulting offers the most advantage in this huge, fragmented market.

From service lines and geographies to consolidation, new technologies, and commodification, the information technology services industry is dynamic and offers both opportunities and risk for major global vendors.  Accenture (ACN) remains the best-positioned IT services company, given its breadth and depth across all market segments, and we believe it has a wide economic moat. Narrow-moat  Cognizant Technology Solutions (CTSH) also has a strong competitive position.

IT Services Market Is Large and Fragmented
Global IT services spending is enormous, estimated at $922 billion in 2013. Over the next five years, we expect the total market to grow at a compound annual rate of 5%. We separate the IT services market into six key areas: consulting, systems integration, IT outsourcing, business process outsourcing, software support, and hardware support. In this article, we focus on the first four categories.

The IT services market is highly fragmented. The top 10 vendors account for just 24% of the market, with hundreds of other firms offering IT services in various forms.  International Business Machines (IBM) holds the leading market position with 6.1% share, followed by  Hewlett-Packard (HPQ) with 3.5% share and Accenture with 2.9% share. Other firms we cover that fall in the top tier include  Capgemini (CAP),  Computer Sciences (CSC),  CGI Group (GIB)/(GIB.A), and Cognizant, each of which has global market share between 0.9% and 1.4%.

Strongest Advantages Come From Consulting
Consulting is the highest-value service offered because of its complexity and relationship-driven nature. Consulting involves advising clients on IT strategies that support business objectives. Such services can range from operational initiatives such as whether to implement an enterprise resource planning or customer relationship management application, or broader analysis such as the relevance of a company's current IT infrastructure. Consulting can also lead to downstream opportunities in systems integration, IT outsourcing, and business process outsourcing.

Systems integration involves linking together different enterprise software and hardware so that they function as a coordinated whole. A good example would be an SAP enterprise resource planning implementation. Consulting and systems integration are characterized by distinct projects that have defined outcomes and finite time periods. Therefore, demand for these services tends to fluctuate depending on macroeconomic conditions.

IT outsourcing applies to technical work such as application development and maintenance, data center operations, or application hosting. Such services are often outsourced by companies with limited internal expertise or financial resources to reduce complexity and drive cost savings.

Business process outsourcing deals with less technical workloads such as document management, payroll and benefits, customer service, finance and accounting, and supply chain services. IT outsourcing and business process outsourcing involve a company's daily operational needs and are typically nondiscretionary. They often use multiyear contracts that provide a more consistent source of revenue. Nevertheless, we think switching costs are lower in IT outsourcing and business process outsourcing than in consulting or systems integration. As business process outsourcing has become increasingly standardized and automated, we see a high degree of competition from lower-tier providers.

Consulting is the most profitable segment of the IT services market and is also expected to see the fastest growth over the next five years. We project a 6.6% compound annual growth rate as increasingly complex IT environments drive demand for consulting services. While systems integration also provides relatively healthy margins, we expect growth to be muted (a 3.9% compound annual rate) because of a shift from custom application development to more standardized "off-the-shelf" products. In contrast, intense competition and commodified services result in lower profitability for business process outsourcing and some IT outsourcing services. We anticipate that both of these segments will generate 5.9% annual growth over the next five years.

Vendors Consolidate, Shift to Global Delivery
The highly fragmented and specialized nature of the IT services industry helps to explain why many clients use multiple vendors. Historically, clients have pieced together a portfolio of individual specialist solutions to meet specific business or project needs. This approach is changing as clients seek to lower costs and reduce IT complexity, and we anticipate a shift toward top-tier vendors providing end-to-end services. At the same time, IT services providers are also consolidating through mergers and acquisitions as they seek to bolster their size, scope, industry depth, global delivery capabilities, and intellectual property.

IT services companies are increasingly directing their attention to four areas: social, mobile, analytics, and cloud computing, or SMAC. We think these technology transitions will drive healthy demand for those vendors with the best SMAC service portfolios.

Social media is disrupting traditional marketing activities, providing an opportunity for vendors to offer digital marketing services that help companies take advantage of platforms such as LinkedIn, Facebook, and Twitter to boost customer engagement and build their brands. The proliferation of mobile devices is changing the way consumers, enterprises, and governments access digital content. IT services vendors can help enterprises manage the transition to mobile-ready platforms. The exponential growth in data creates an opportunity for IT services vendors to provide analytical tools to help clients garner valuable business insights and build competitive advantages. Lastly, improvements to cost efficiency, business agility, and capital intensity are causing many enterprises to embrace cloud computing, and IT services vendors can help with cloud-based implementation and consulting services.

We think Accenture is strong across all IT services segments and is the only services company to receive our wide moat rating. The company generates plentiful free cash flow and has robust intellectual property (bolstered by acquisitions), unmatched global delivery capabilities (with 305,000 employees spanning 120 countries), and very strong client relationships (more than three fourths of the Fortune Global 500 are clients).

While Cognizant is based in the United States, it primarily uses an offshore workforce in India. The company is well positioned for a variety of trends in IT services, and we expect it to increase earnings well in excess of the industry average. Cognizant was an early champion of SMAC technologies, and its client-first attitude has led to unusually strong client relationships.

We expect modest growth for Capgemini as increased offshoring hurts the competitiveness of its large workforce in Europe. The company is working to improve its global delivery capabilities; its offshore employee base has expanded 36% since 2011 while onshore head count remained flat. An entrenched position in Europe makes Capgemini a valuable partner to technology vendors and multinational clients.

CGI Group
We don't expect the high-profile problems surrounding CGI's contract to have a material adverse effect on its business. The company has a strong presence in government and public services work. While much of CGI's workforce is located close to customers in North America and Europe, the acquisition of Logica improves global delivery capabilities.

Computer Sciences
Because of past management missteps and poor strategic execution--including accounting issues, underperforming contracts, and commodified services--we don't believe CSC has an economic moat. However, new management has implemented a multiyear turnaround strategy, and initial signs are encouraging. 

Andrew Lange does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.