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Stock Strategist Industry Reports

Outsourcing 2.0: IT Services' New Wave

Technological adaptation and moderating revenue growth will characterize the next stage for Indian IT services firms.

Over the past decade, Indian IT services providers  Tata Consultancy Services (TCS),  Wipro (WIT), and  Infosys (INFY) have emerged from relative obscurity to become IT services behemoths rivaling traditional Western incumbents such as Accenture (ACN) and Capgemini (CAP). Over this time, explosive growth in revenue (20%-40% annually) and head count (also 20%-40% annually) has been fueled by labor arbitrage and a lower-cost delivery model. We believe TCS, Wipro, and Infosys now sit at a crossroads, and strategic decisions being made today will have major implications for future financial performance and competitive positions.

We think the IT services industry is fundamentally changing and vendors will no longer be able to rely solely on their low-cost position for outsize revenue growth. Developments surrounding automation and social, mobile, analytics, and cloud (SMAC) technologies are expected to usher in a new era of outsourcing in a movement that we call Outsourcing 2.0. Here, we believe clients will demand more than just cost savings; they will increasingly seek consulting partners that offer technologically differentiated services based on new technology platforms and tools. So far, we think TCS, Wipro, and Infosys are appropriately adapting to the challenges of Outsourcing 2.0 and deploying capital to the right areas. Advantages in global delivery, domain expertise, and financial resources should help protect these vendors from any precipitous slide in competitive positioning over the long term.

Technological Developments, Client Demands Changing the Game
Over the past decade, labor arbitrage and a lower-cost delivery model have been the predominant tailwinds for outsize growth rates among many of the IT services players. During this time, revenue surged 739% at TCS, 418% at Wipro, and 432% at Infosys while employee head count grew 557%, 249%, and 336%, respectively. In a global environment where cost reductions are the normal course of business, such growth was fueled predominantly by Western companies seeking to take advantage of an efficient, low-cost workforce, in what we call Outsourcing 1.0. However, given changing technological developments and more sophisticated client demands, we think the Indian IT services industry sits at a critical juncture. Increasingly, companies in mature markets such as the United States and United Kingdom are looking beyond the traditional Outsourcing 1.0 mandate and incorporating new and emerging technologies that help their businesses operate in meaningfully different ways. We call this new era Outsourcing 2.0.

In the Outsourcing 2.0 era, the leading Indian IT services vendors must adapt to the changing demands of clients and provide more than just traditional cost savings. We believe developments surrounding automation and SMAC technologies will spur a new era for the Indian IT services vendors as clients explore ways to differentiate themselves in a competitive marketplace. We expect new technologies to provide clients with new operating and economic models that will help to deliver revenue growth, lower cost of goods sold, and improved profitability.

We think major corporate enterprises operating in more mature markets such as the U.S. and U.K. have essentially completed much of the traditional "lift and shift" of people and existing processes. Now they are seeking new ways to gain a competitive edge, even if temporary. We believe automation and SMAC technologies represent viable routes to success, and the more sophisticated Western clients are increasingly exploring potential investments in these areas. We believe TCS, Wipro, and Infosys must adapt their portfolios to meet this new environment, especially considering that the overwhelming majority of an Indian IT services provider's revenue is generated in the U.S. and Europe.

Supporting our view of the market's underlying change, a recent survey from HfS Research found that the desire of buyers to shift away from purely legacy labor arbitrage will be significant over the next two years. Wide-scale transformation of business processes enabled by new technology tools and platforms will be the most desired engagement model, as doing so in the era of Outsourcing 2.0 will create greater business value for the client.

TCS, Infosys, Wipro in Unique Position for Outsourcing 2.0
Relative to the thousands of other smaller players in the market, the three Indian IT services giants have advantages in global delivery, domain expertise, and financial resources. And these vendors have already started adjusting their traditional head count-led growth models to incorporate new technology tools and platforms, which we believe can protect them from any precipitous slide in competitive positioning over the long term.

So far, we think TCS, Wipro, and Infosys have been smart in adapting to the changing market. With technology-led differentiation becoming all important, the three firms are quickly deploying new tools and platforms in order to better engage clients. Rather than holding on to the traditional way of working and languishing at the commodified end of the IT services industry spectrum, we have seen the vendors go upmarket and offer newer services (where pricing and margins are more defensible), especially around SMAC.

The dual mandate of helping clients run more efficiently while providing technological differentiation has been the motivating factor behind the SMAC technologies movement. HfS Research noted that nearly half of the large global IT deals signed in July 2014 had a core that was either digital or SMAC, and research provider Gartner has reached similar conclusions via its customer surveys, underscoring its increasing importance. We think these new offerings will allow the India-based firms to better compete with global Tier 1 IT services companies.

Each of the three IT vendors generates more than $1 billion in free cash flow per year (based on an exchange rate of $1/INR 60) and has low to nonexistent levels of debt. We believe this financial strength puts TCS, Wipro, and Infosys in a powerful position, with the flexibility to acquire new and emerging technology. Over the past few years we've seen TCS acquire high-performance computing and cloud services company Computational Research Laboratories; Wipro acquire cross-industry analytics company Promax Applications Group; and Infosys acquire automation technology specialist Panaya. Furthermore, each vendor has explicitly stated that IP development associated with process automation and IP development in SMAC will remain high priorities.

Hypergrowth Days Are Gone
We think the Indian IT services providers cannot sustainably grow at historically high levels (20%-40% annual revenue growth) for three key reasons:

(1) The U.S. and U.K. markets are maturing, and their growth rates have moderated. According to Gartner, over the next five years, revenue from the North American market is expected to grow 5.5% per year and the Western European market is forecast to grow 3.9% per year (historically these markets have grown approximately 6%-7%).

(2) We think the law of large numbers means it will become increasingly difficult to post such tremendous growth rates. For instance, in order for TCS to continue to grow at 30% annually over the next three years, the company would have to generate an additional INR 245 billion in fiscal 2015, INR 320 billion in fiscal 2016, and INR 415 billion in fiscal 2017. This compares with the recent past, when the company's growth was driven off a much smaller revenue base and the 30% clip was achieved through yearly revenue growth of "just" INR 50 billion-100 billion.

(3) With clients focusing slightly less on labor arbitrage and placing a greater emphasis on technological differentiation, we think the industry will become a more level playing field. Instead of relying centrally on labor arbitrage to win deals, in order to appeal to new and existing clients the Indian vendors will have to increasingly leverage expertise across key competitive pillars such as relationships/branding, industry expertise, and intellectual property, in our opinion. In our view, it will be increasingly difficult for TCS, Infosys, and Wipro to differentiate themselves when paired against Western rivals.

Contrary to some opinions, we still expect labor arbitrage to remain a key component for the Indian IT services vendors, and we're not assuming that this benefit evaporates quickly. Although wage inflation for an Indian IT worker is often 3-5 times that of a U.S.-based worker, given the current wage disparity between workers in both countries we estimate that it will potentially take decades before the pay of a typical Indian IT worker hits parity with a U.S. IT worker.

Some pundits have argued that Indian wages have become equivalent with U.S. wages, and while this may be so in some high-level or niche areas, on the whole, this is not the case. After analyzing average pay scales between the U.S. and India, we have concluded that the disparity between U.S. and Indian IT workers remains significant across a variety of IT jobs. In some cases, an Indian IT worker can cost one tenth the cost of an equivalent U.S.-based worker, depending on foreign exchange.

Given this market analysis as a backdrop, we think the Indian vendors will continue to be price-competitive relative to Western providers. From a cost standpoint, labor arbitrage remains an important lever that TCS, Infosys, and Wipro can pull. According to our estimates, the Indian vendors are often able to price at a 10%-30% discount relative to Western competitors. Structurally, a full offshore business model, as opposed to a partial model, is one important factor. As of April 2013, 92.3% of TCS' head count was Indian (the firm no longer publishes this metric), and according to a lawsuit, approximately 90% of Infosys' workforce is South Asian. This is in stark contrast with Accenture, which has 66% of its workforce offshore, and Capgemini, which has 46% offshore (neither gives specific Indian head count figures). We think this distinction will continue to allow the Indian vendors to differentiate on price for at least the medium term.

Labor Arbitrage, Automation Will Support Margins
In our view, flexibility in the labor arbitrage model can be exploited to ensure stability in margins. There are three key reasons for this. First, TCS, Wipro, and Infosys have and will continue to shift work to Tier 2 and Tier 3 Indian cities. According to the National Association of Software and Services Companies, these cities have 10%-20% lower operating costs and a 10%-25% lower cost of living than Tier 1 cities. Second, alternate geographies can be pursued, such as the Philippines, Eastern Europe, and Latin America. Third, continually hiring new graduates, in addition to natural attrition and a healthy supply of engineers, helps to keep wage costs lower. For example, approximately 40% of TCS' workforce has less than three years' experience.

Therefore, with employee costs totaling approximately 50% of group sales for TCS, Wipro, and Infosys, we think such labor-focused initiatives will support stability in group operating margins.

We contend that head count growth and revenue growth will gradually become less correlated over the coming years as vendors adopt greater automation. As a result, we expect automation to counterbalance employee wage inflation (in addition to labor arbitrage) and support stable long-term margins. To this end, Infosys and Cognizant have partnered with automation specialist IPSoft, while TCS and HCL Tech have plotted a different course and built automation tools in-house. Meanwhile, industry rumors suggest Wipro is considering reducing its head count depending on how quickly automation can be deployed throughout the organization. Not coincidentally, the majority of job losses are expected to be in computer infrastructure monitoring and administration.

Pullback Could Present Good Buying Opportunity
Based on current valuations, we think each vendor looks fairly valued. Still, we think these companies remain well positioned over the long term, and any meaningful pullback in price could present an opportune buying time for investors wanting exposure to high-growth, international IT services providers. We favor TCS, all things being equal, but Wipro and Infosys would still be suitable investments if they were to enter 4-star territory.

In the large fragmented IT services industry, we think TCS, Wipro, and Infosys will continue to take market share from large encumbered rivals, and small, less well-rounded vendors. While the overall IT services market is expected to grow approximately 5% per year over the next five years (according to Gartner), we expect the Indian vendors to continue to outperform the market and post midteens to high-single-digit revenue growth. Labor arbitrage and Outsourcing 1.0 will remain a driving force behind this growth as long as the firms can appropriately adjust for the forthcoming shift in buyer behavior toward Outsourcing 2.0. So far, we think TCS, Wipro, and Infosys have done a good job adjusting to this new-normal operating environment.

In addition, with vendor consolidation becoming a major theme in the industry (something we highlighted in a previous Stock Strategist Industry Report, "An Evolving IT Services Market Warrants Investors' Attention"), from a client perspective, we think the Indian vendors are in a good long-term position relative to small vendors because of advantages in global delivery, domain expertise, and financial resources. From a provider perspective, given the size and financial strength of TCS, Wipro, and Infosys, these vendors have a better ability to acquire brands, expertise, and intellectual property to bolster their already sturdy competitive positions.

TCS, India's largest IT services vendor, has outperformed peers such as Infosys and Wipro, and we think it will continue to outpace rivals. The company's long-term success can be primarily contributed to its high-quality, stable management team and its corporate strategy. CEO Natarajan Chandrasekaran streamlined TCS and created more-agile business segments focused on specific verticals and geographies. As a result, one large company has the energy of many smaller companies and allows each business unit to focus on industry- or region-specific issues.

TCS has always taken a more customer-centric view of the market, while peers have been more focused on growth and profits. For TCS, this has led to better project execution, customer satisfaction, and employee retention (TCS' attrition was 13.4% in the recent quarter, well below Infosys' 18.1% and Wipro's 16.4%).

Thanks to its position as a low-cost vendor, TCS leads the industry in terms of revenue growth and operating margins. With a more customer-centric view of the market, one might expect TCS to generate lower growth and profits. However, scale helps in this business, as the firm can spread overhead across more people. TCS has more than 320,000 employees (Infosys has roughly 170,000, while Wipro has approximately 155,000), which gives it a distinct advantage. In addition, the firm has made a concerted effort to keep its employee pyramid as flat as possible (meaning a greater reliance on a low-cost, entry-level workforce), which supports its margins. 

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