Its strength is determined not only by capacity to spend but a host of other key factors, with the outlook on growth having become the more limiting one
Conventional thinking suggests IT Services spending should be closely related to corporate profits/balance sheets at the corporate level (micro level) and GDP at the broader economy (macro) level. Today, US IT Services spending as percentage of US Corporate profits is still below levels it stood pre-Lehman (pre-2008/09). Logically speaking, improved balance sheets, cash flow generation and profitability of corporates, expected reversion to mean (of US IT Services spending as percentage of GDP/total corporate profits) and rising intensity of IT Service spending in the economy suggest that IT services spending should strongly rebound. Yet, we’ve not seen evidence of this to the expected degree in the last two years despite the mounting excitement around digital/SMAC that IT Services companies have been referring to for a while now. Why has this been so and is this going to be an enduring state of affairs? We investigate a few causes in this report together with our view of what it would take for US IT Services spending (including offshore IT Service spending) to rebound vigorously.
Generally speaking, IT Services spending depends on what we call the three point agenda: (i) the ongoing imperative to drive simplification, optimisation and efficiencies (this is where India IT traditionally plays well)—spending here is steady at best but more realistically like a slowly melting iceberg, (ii) restructuring and reorganisation for achieving competitive advantage/parity (which is where parts of the digital transformation agenda kick in) and (iii) outlook on growth/demand which in turn influences growth capex/opex. There may be other extraneous factors as well telling on IT Services spending, such as the strengthening US$ impacting US$ profits/US$ cash flows of US-headquartered diversified corporates, which in turn could adversely impact investments (including IT investments). We don’t consider such extraneous (e.g. currency-induced) factors in our analysis in this note, but acknowledge that the strengthening US$ makes such an analysis relevant.
What is the limiting factor for IT Services spending today? Of the three point agenda, the third factor (i.e. outlook on demand/growth) is the more limiting factor today. Less limiting is firms’ investment capacity/optimisation. This means that even as corporates feel more comfortable about their cash positions, liquidity, and cost structures today than say, three-four years back, they will probably not write out the cheque book for growth investments (such as expansionary/growth based IT Services spending) unless they see signals of demand/growth picking up. Perhaps this explains why the near perfect correlation (or lockstep) between IT spending and corporate profits of the past is weakening of late. A stronger balance sheet, enhanced liquidity and/or a better cost structure may not be sufficient by itself to spur investments beyond a degree. We think that this is quite unlike the scenario pre-Lehman when investment capacity was the constraint. The correlation between IT Services spending and corporate profits is weakening of late but that between IT Services spending and revenue growth remains strong. (Revenue growth is taken as a proxy for demand uptick).
Also, cash returns to shareholders by S&P 500 (dividends+buybacks) have grown significantly over the past two-three years crossing $900 bn in 2014 (& possibly topping $1 trillion in 2015). Growth in cash returns for S&P 500 has far outstripped profit/cash flow growth—thus suggesting that if firms do not find legitimate business reasons to duly invest their cash/profits, they prefer to give it to shareholders.
The second-part of the three point agenda, which deals with driving future competitive advantage/parity using digital as a transformation tool is receiving much attention today. Transformational spending centring on digital is growing strongly off a small base today. Can this be a significant driver of IT Services spending into the longer term and not just today? Yes, provided clients perceive adequate returns on their present digital investments, which will justify continued spending. But digital still operates in a somewhat hazy context despite immense promise. One reason could be that unlike previous waves of spending (say ERP, internet), there might not be as clear and well demarcated roadmap for the clients on the digital journey as they’d like. The framework for value addition here for IT Services is still evolving. It is as much clients charting out their way to get the most from digital as vendors helping in defining the milestones on the digital journey. That said, sometimes, all it takes to ignite spending in this area is for a pioneer or two in every industry to take the lead with demonstrated benefits for others to follow. So, spending by competitors that is perceived to confer competitive advantage can ignite catch-up spending. To illustrate, a wholesale bank may not necessarily be spending as much as it really should on certain new-age initiatives in mobile banking unless it sees evidence that the same is benefiting its competitors.
Furthermore, the second point of the three-point agenda (i.e. spending for competitive advantage/parity) is also in focus due to threat of newer/emerging business models threatening the incumbents. New business models which break existing industry value chains and pose growing risk to traditional/legacy models are forcing the traditional incumbents to react/readapt. Nowhere is this more evident than in the case of brick and mortar retailers (e.g. Barnes and Nobles) who are facing an onslaught from online/digital retail plays (Amazon). Brick and mortar will step up their investments to safeguard themselves and direct an increasing portion of their investments towards the new.
To sum up, more than only corporate profitability/liquidity, which defines capacity to spend, and ongoing simplification of the existing IT landscape (which really is ‘base line’ spending), we must also look for additional signals of willingness to spend such as: (i) Revenue growth expectations (proxy for demand uptick) or the third point of the three point agenda—this is the most important longer term factor; subdued revenue growth optimism is likely limiting IT Services spending today, (ii) fear of not being able to keep up and (iii) survival spending in the face of new business models and dissolution of traditional value chains—these are additional factors in the mix of variables determining the strength of US IT Services spending. Else, firms might just prefer to return cash to shareholders via dividends/buybacks on an increasing basis, which is what we’re seeing in the US (S&P 500) since 2012. We stay OW on Infosys, HCLT and Tech Mahindra. From the Indian (offshoring) IT Services perspective, we continue to believe that it is essential for the investment community to take a bottom up view, not just a top down view. Within the larger firms, we see differential ability to handle base and build diversity in the business model.
Moreover, digital/SMAC is not the same as capacity-based wave as past waves (ADM/BPO/ ERP maintenance) saw fairly comparable growth for Tier I companies in 2003-08 when ADM/BPO/ERP went offshore. Past waves worked in Indian IT because they were labour intensive and ripe for offshoring, and, more importantly, were established already to some degree by legacy MNC vendors (IBM) or done in house onsite, which shifted offshore for cost savings and subsequent process improvements. Digital is a new paradigm, which has to be shaped—creation of something NEW leads to strikingly different/polarised outcomes among players over time as there is no set process/offshoring template. Winning in digital requires a more aggressive partnering and M&A mindset among other things.