Digital shift continues, with more consolidation and pricing pressure In partnership with UBS Evidence Lab, we expanded our IT user survey this year to include Japan, targeting 220 decision makers from large enterprises in the US, the UK, France, and Japan. The participation rate for offshore IT users increased from 78% in 2015 to 90% this year. Digital adoption rates have accelerated, with 87-100% penetration in the respondent base in 2016 compared to 16-73% in 2015.
Most respondents expect increased IT services spending as a result, but are keener on vendor consolidation and price negotiations—trends we have observed in vendor commentary and revenue in recent months. Accenture, TCS and HPE’s rankings improved from the 2015 survey IBM and Accenture once again topped the rankings for preferred vendors in digital. Accenture moved up from a distant second in 2015 to being neck and neck with IBM. TCS was the only offshore vendor in the top 5, backed by a strong showing in the UK. Cognizant, Infosys and Luxoft moved down the rankings in 2016.
Fujitsu and NTT DATA performed well in the Japanese market. Overall, western-heritage vendors continue to dominate mindshare, which we think is due to a proactive acquisition of digital skills compared to their offshore counterparts. Some key findings point to medium-term/structural pressures 66% of respondents still save up to 20% in IT costs through pure offshoring, proving that fears over a revenue decline for offshore vendors have been exaggerated. However, 43% of respondents expect to save more than 20% in IT costs, which implies that offshoring alone is unlikely help achieve cost targets, and clients will seek digital as an incremental means to save costs. We expect smaller contract sizes and an increased reliance on in-house skills to impact revenue growth in the medium term for all legacy vendors (link).
We remain selective; our top picks are Capgemini, Atos, Fujitsu, EPAM, HPE Overall, we remain cautious on the IT services space as the transition to digital could continue to strain legacy services exposure for these companies. We believe not all legacy vendors will transition well into digital services, and remain selective in our picks. We have Buy ratings on Capgemini, Atos, Fujitsu, Hewlett Packard Enterprise (HPE), and EPAM Systems (EPAM), where we see positive risk-reward. We have a neutral stance on Accenture, Tata Consultancy Services (TCS), IBM, Cognizant, Hitachi, HCL Technologies (HCLT), and Luxoft, and Sell ratings on Infosys, Wipro and Tech Mahindra.
PIVOTAL QUESTIONS Q: Is the adoption of digital services slowing legacy revenue momentum? Yes. Digital services adoption continues to accelerate, with increased penetration of key technology segments. However, smaller contract sizes in digital, when combined with the pressure on legacy services and vendor consolidation initiatives, will likely increase the strain on legacy services revenue.
While traditional levers such as offshoring remain effective, the need for even higher cost savings is likely to lead to faster adoption of digital services, at the expense of legacy revenue. more
Q: Are all legacy vendors likely to benefit from the move to digital?
No. We believe vendors that aggressively self-cannibalise and acquire new capabilities will garner a disproportionately larger market share. At present, the likes of Accenture and IBM have been more proactively adding digital expertise via M&A, while many offshore vendors have been more reticent in their approach to adding capabilities inorganically. We believe the latter group of vendors is still playing catch-up in terms of mindshare and market positioning, allowing the former to capture a greater share of digital transformation engagements with IT users at present. more
WHAT’S PRICED IN?
The market is rightly concerned about disruption. Increasing industry and third-party advisor data have reinforced the view that legacy services revenue is now increasingly being disrupted by digital technologies. We believe the broader markets are now beginning to price in such a disruption, with many services stocks either flat or declining year-to-date. However, we believe the market is still unsure about the structural impact on medium-term revenue and earnings momentum, and therefore is sticking to stocks that are perceived to be high-quality, even if some still have downside in the form of a structural de-rating in valuations. UBS VIEW We remain selective in our stock picks. We believe the shift to digital services is a disruption (not a mere cyclical problem) that will benefit vendors to an extent that is proportionate to their ability to effectively reorient their business models to address changes in customer needs. We believe the market needs to remain selective, preferring vendors that have the ability to effectively adapt to digital or have already been pricing in cannibalisation for the same reason. Divergence in vendor performance;
IT user survey confirms our views: In the last two years, vendors’ revenue performance has started to diverge, with the likes of Accenture seeing steady momentum on the strength of their digital transformation initiatives. Others, like Cognizant and Infosys, which have yet to fully optimise their portfolios to digital, have seen disappointment. Our UBS Evidence Lab survey indicates that IBM, Accenture, Atos, and HPE have strong client mindshare. Offshore vendors are still playing catch up according to respondents, with only TCS seeing a significant improvement in rankings in 2016.
The survey also confirms our views on smaller contract sizes in digital and the need for significant cost savings that is increasingly being sourced through pricing pressure and consolidation.