Published on 1/01/2018 1:21:30 PM | Source: Kotak Securities Ltd

Indian IT has invested over US$1 bn in the last few quarters - Kotak Sec

Posted in Broking Firm Views - Sector Report| #Kotak Securities Ltd #IT Sector #Sector Report

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Understanding IBM IP deals. Indian IT has invested over US$1 bn in the last few quarters to gain access to IBM’s library of IP revenues with hopes of mid-teens IRR. Investors do not seem to share this optimism on IRR. IBM’s rationale is to outsource development of IPs to partners that can innovate while freeing up resources for best opportunities. We believe the single point determinant of the IRR in these deals is revenues, which with limited information is difficult to forecast. We detail our thoughts and believe such deals lack strategic benefits.

The service provider perspective

Indian IT companies have lapped various IP licensing deals from IBM over the last six quarters in the areas detailed in Exhibit 1. The rationale outlined by IT companies for these deals falls in the following areas—(1) entry into and understanding the dynamics of the IP business, (2) high synergy value derived through sell-with and sell-to strategies, (3) access to a high quality client base, (4) creation of derivative IPs which can be potential money-spinners. This combined with mid-teens IRR, at the least per Indian IT, makes these deals attractive. We do not share this service provider optimism and believe these deals have limited strategic benefits.

The IBM perspective on IP deals

IBM has entered into well over 20 IP partnerships over the past two years of which six are with HCLT, one with Tech Mahindra and one with Wipro. IBM recognizes the upfront money paid by partners as IP income. Here is an extract of IBM’s IP strategy from its 1QCY17 earnings call -

* IBM’s clients see the value in the company’s IP, but it requires continuous innovation to stay in high value spaces. IBM is forming IP partnerships to enable ongoing innovation in IP while allocating development resources to where it sees the best opportunities.

*  In these partnerships, IBM licenses, but does not sell, source code to a technology or services partner who assumes the development rights and invests to innovate and build new functionality, enhancing the value of the IP. This, in turn, reinforces and supports IBM’s revenue stream. IBM retains the ownership of the IP and the revenue streams and pays a royalty to the partner for the enhancement of the IP.

* As the partner (HCLT as a case in point) sells to their clients they pay a royalty back to IBM from the revenues they receive. The benefits of these IP partnerships to IBM include (1) prioritization of development resources, (2) continued innovation for clients based on IBM’s high-value assets, and (3) the creation of additional channels, which can expand the client base.

Summing it up, the ability to monetize is driven by the amount of IP that IBM creates, which is substantial, whether or not a transaction occurs in a particular period. Because IP is high value and relevant to IBM’s clients, it is also attractive to a broad range of technology and services partners who can build solutions around the core assets. To put this in perspective, IBM has licensed, on a non-exclusive basis, over 1% of its software code base through these agreements to date.

The deal structure-derivative IPs are a critical component

Based on disclosures in earnings calls and a detailed analysis, we believe the following are the critical components in the IBM IP deals:

* The products that are licensed by IBM are typically mid-to-end of life products with a solid installed base of clients. The licensing period ranges from 5-15 years. The service provider gets development rights to maintain, enhance, innovate and add new functionalities.

* The deals are revenue share deals. IBM gets compensated through an upfront license payment.

*  Revenue components for service providers are—(1) revenue share of underlying IP for which upfront license fees is paid, (2) derivative IPs that service providers develop. Derivative IP commands a higher share of revenues and is a win-win for the service provider as well as IBM. Derivative IP is a body of code in which new functionality is added to the licensed product and for which the revenue model has to be tweaked, (3) a sell-with strategy wherein the service provider can partner with IBM to implement a product for the client. However, such revenue streams are not large, considering IBM also has its own services arm, and (4) access to the IP client base where the service provider can cross-sell other services.

* Of the above revenue streams, IP and derivative IP revenues are the most important revenue streams to achieve a reasonable IRR in our view.

* The service provider assumes complete responsibility of the cost of revenues i.e. product development. IBM continues to be in charge of sales and marketing. However, the service provider is also free to on-board clients.

* It is logical to assume that the service provider is given access to historical revenue data and flow to analyze and assign value to IP. The service provider normally tracks revenue flows across cycle, changes in the installed base and changes in the revenue stream whenever there is a major upgrade or version release

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