Our Top Picks In IT Services

(BySwami Shanmugasundaram) Withthe global economy in flux, investors have raised questions about thegrowth prospects of IT service providers. This fear has pummeled some ofthe top-tier service providers we cover, and current prices suggest asignificant curtailment of IT services spending in the near and mediumterm. We think this is unlikely, as hiring patterns and order pipelinesindicate that the growth momentum remains strong in the near term.Continued customer focus on cost efficiencies should help outsourcingachieve higher penetration in the medium term. Against this backdrop, wethink narrow-moat firms Wipro (WIT) and Infosys (INFY) trade at large discounts, offering patient investors attractive risk/reward opportunities.

Demand for IT Services Remains Strong Despite Economic Uncertainties
Thoughthe global economy is on a slippery track, we expect IT serviceproviders to hold their ground in the near term. We haven't seen anycracks in IT services spending so far, not even in discretionaryconsulting services. Recent commentaries from Cognizant (CTSH),Wipro, and Tata Consultancy Services indicate that it has been businessas usual in terms of deal signings in the past few months. Accenture (ACN)recently closed its fiscal 2011 with record consulting and outsourcingbookings; its outsourcing bookings were its highest in the past sevenyears. Additionally, given the linear nature of the business model (highpositive correlation between employee growth and revenue growth), wethink employee hiring patterns are good leading indicators of growth.All top-tier players have good records on resource planning and havehistorically increased hiring primarily when they had good visibility ontheir future demand. In that regard, continued strong hiring by thesecompanies backs up our outlook for a robust demand environment in thenear term.

Over the medium term, we expect demand to come from increasedadoption of outsourcing by companies around the world. Though 2009 wasone of the toughest years fo! r IT ser vice providers, we think iteventually turned out to be a positive for their business as it helpedthem acquire more new clients and expand their addressable markets. Thisis in line with the industry's prior experience. Economic downturns orslowdowns typically force companies to evaluate their IT spending andlook for new ways to cut expenses. Given the cost benefits associatedwith outsourcing, we would be surprised if outsourcing doesn't gain moretraction in the coming quarters.

Additionally, Indian players shouldbenefit as they continually invest to expand their reach (in terms ofportfolio of offerings and geography), thereby increasing the size oftheir addressable market.

Troubles at Wipro and Infosys Have a Short Shelf Life
Wiproand Infosys reported lackluster numbers in recent quarters, and wethink this was because of distractions caused by internal organizationalchanges. While the impetus for the change was different at each firm,the result was the same--both now have new senior management in placeand have made slight changes to their service offerings. As tends to bethe case with many restructurings, the changes came at a cost. In thiscase, both Wipro and Infosys lost some of their growth momentum.Further, the changes couldn't have come at a worse time for these firmsas demand for IT services started to downshift in 2011 after a period ofstrong growth (driven by pent-up demand) in 2010.

Wipro Has a Two-Pronged Strategy to Reinvigorate Growth
Wipro'sgrowth strategy is to increase penetration in its existing client baseand focus more on high-growth industry verticals. Wipro's troubles weremostly because of its poor client mining and an unfavorable portfoliomix. Its reorganization initiatives were aimed at these shortcomings andshould improve its short- and long-term growth opportunities. Wiproboasts a strong record in terms of signing new accounts and expandingits client base, as is evident from its 900-plus active clients. Thefirm's problems have ! come lat er, in managing client relationships andexpanding accounts. In an effort to use its vast client base moreeffectively, Wipro has streamlined its account management model andinstituted a more client-centric approach. In the new model, each clientaccount has one dedicated account manager rather than multiple pointsof contact. Wipro's recent results indicate that it has made progress inscaling up some of its larger accounts. The firm finished the firstquarter of its fiscal 2012 (ended June 2011) with four $100 million-plusaccounts, up from one at the end of the third quarter of fiscal 2011.While recent improvements are encouraging, Wipro still lags its peers inthis area. At the end of June, Infosys and TCS had 11 and 10 $100million-plus accounts, respectively.

Wipro's growth is also hindered by its portfolio mix. The firmcurrently has low exposure to the fast-growing financial servicesvertical (in terms of IT services spending), while it maintains highexposure to the weaker technology sector. The company derives about 25%of its revenue from financial services, which is the lowest among theTier 1 service providers. TCS and Cognizant depend on financial servicesfor more than 40% of their revenue, while Infosys generates 35% of itsrevenue from this vertical. As a part of realigning its industry mix,Wipro plans to focus on four high-growth sectors: financial services,energy and utilities, retail and transportation, and health care.

Though we expect these initiatives to take some time to improveWipro's performance, initial results look promising.

Revenuecontribution from the company's four core industry verticals increasedto 63.5% from 61% last year, and there has been a notable increase inthe number of clients who contribute more than $10 million in revenueper year.

Strategic Transformation Will Hurt Infosys in the Near Termbut Should Help Achieve Above-Average Growth with Industry-LeadingMargins Over the Long Term
Infosys has been the face of theIndian IT services industry! for mor e than a decade. It earned itsposition by consistently delivering industry-leading results. However,the company failed to live up to expectations in the past two quarters,as its revenue growth underperformed its peers.

Infosys' sequential growth during the past two quarters came in at 1%and 4%, respectively, while Cognizant and TCS delivered mid- tohigh-single-digit growth during the same time frame. While twoconsecutive quarters of underperformance is a cause for concern, webelieve the market was spooked more by management's conservativecommentary than by its recent numbers. Infosys has been the only Tier 1IT service provider to consistently maintain a cautious stance on thenear-term demand environment. We think its relatively poor results andcautious commentary are mostly due to distractions caused by thetransition to its new Infosys 3.0 strategy and management changes.Additionally, client-specific issues continue to take their toll.

In May, Infosys unveiled a new organizational structure, Infosys 3.0,aimed at better positioning the firm for growth. This primarilyinvolved realigning the company's business along four industry verticalsand three horizontal service functions. Infosys was one of the firstIndia-based outsourcers to align its business along industry verticals;this has been its go-to market strategy since 2003. As a part of 3.0,the company identified seven strategic themes based on key demanddrivers and then regrouped its industry verticals along these themes.Additionally, it redefined its services practice along three broadcategories, one of which is innovation. The innovation practice istasked with strengthening the nonlinear initiatives that span the firm'sproducts and platforms.

Given the maturity of the global delivery model and asupply-constrained labor market, we like Infosys' new approach. Thecompany is relying more on its nonlinear initiatives and high-endservices (such as consulting, system integration, and packageimplementation) to maintain its industry-leading gr! owth and marginprofile. While most of the Tier 1 service providers have been talkingabout these initiatives in one form or another, Infosys was the firstIndian company to put a structure in place.

In addition to these realignments, Infosys used this restructuringprocess to decentralize its decision-making process. Taken together,these events caused some friction within management and led to thedeparture of a few senior executives, but the company retained most ofits core management team. The restructuring also caused somedistractions as people changed roles and took some time to settle in.While we don't know the exact timeline behind the planning stage, it'sclear that Infosys chose a bad time to implement those changes. Theymostly coincided with the sovereign debt crisis flaring again and theglobal economy showing signs of a slowdown. Nonetheless, we think thecompany has largely completed its restructuring process.

Infosys did a similar reorganization in 2003 (when it first groupedits operations around industry verticals), and its performance declinedtemporarily then as well. However, the company was successful andrevenue growth bounced back strongly after that. We think it's highlylikely that the company will be able to pull this one off.

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