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ISG data points to an unabated demand momentum

ISG, a leading global advisor to the IT Services industry, hosted its 3QCY21 industry call to discuss deal bookings during the quarter. With record deal signings in 3QCY21, along with commentary on sustained end-market demand, we reiterate our positive stance on the IT Services sector.

Here are the key takeaways:

Strong demand to compensate for supply pressures, prefer Tier I players

* While we continue to see a strong demand environment for IT Services companies over the medium term, we were positively surprised by the pace of growth, breadth across regions, type (traditional and as-a-Service), and volume (highest ever in total, multi-year high for mega deals). With ISG indicating good visibility on tech spends even in CY22, we expect revenue growth to remain solid for Indian IT Services companies over FY22E/FY23E.

* Despite near-term headwinds on the supply-side (also highlighted by ISG), we expect margin pressure to start easing in FY23E due to strong fresher intake and better pricing of new work, as indicated by most companies during our AGIC.

* ISG’s upbeat commentary and deal momentum in ER&D services (Exhibit 2) was also in line with our strong preference for the sector, as LTTS remains our top pick in Tier II IT. We remain convinced of long-term growth tailwinds for ER&D, led by increased outsourcing and larger deal sizes.

* We continue with our preference for Tier I IT, given their strong competitive positioning and relative attractiveness on valuations. INFO and HCLT are our preferred picks within Tier I IT.

Record high ACV bookings, with strong growth across buckets

* Overall ACV (annual contract value) increased by 40% YoY in 3QCY21, with as-aService/Managed Services market up 56%/22% YoY.

* For 9MCY21, growth in as-a Service was dominated by 36% YoY growth in IaaS, while SaaS witnessed 26% YoY growth. Growth in Managed Services was led by 40% YoY growth in BPO (on a lower base) and 12% growth in ITO.

* ACV was up 37% YoY in Americas, while EMEA posted 36% YoY growth. Managed Services in Americas/EMEA grew by 22/21% YoY.

Positive commentary and upgrade in outlook

* ISG has once again upgraded its outlook for both Managed Services and as-aService. It now expects: 1) Managed Services ACV to grow by 10.1% YoY in CY21E (v/s its earlier forecast of 9% YoY), and 2) as-a-Service ACV to grow by 25% YoY in CY21E (v/s its earlier forecast of 22% YoY).

* ISG sees a broad based recovery driving growth momentum in Managed Services. Moreover, it believes that as-a-Service appears to be in the early phase of a long term secular growth.

Supply-side pressures

* ISG echoed concerns around supply-side challenges. India attrition rates for early stage Digital talent are as high as 50%. It sees near term margin headwinds from supply-side challenges.

* Service providers are tackling supply-side challenges by stepping up hiring for both campus and laterals and using sub-contractors to fulfill immediate demand. We expect the industry to sail through supply-side headwinds in the medium term, given the strong and industrywide fresher intake.

* Service providers are witnessing some ability to pass on wage inflation to clients via price increases. However, this is largely for new contracts, where ISG sees 4% increase in pricing for contracts in CY21 v/s CY19 levels. But rate cards for existing contracts continue to stay as per contracts as re-negotiation of the same is difficult. Hence, ISG expects near-term headwinds on margins.

Strong traction for ER&D services

* ISG indicated increased traction in Engineering R&D (ER&D) deals, led by increasing activity and larger deal sizes. ER&D ACV is growing at triple-digits, and 3QCY21 ACV witnessed a growth of ~300% YoY.

* ISG sees engineering transformation spanning both strategy and implementation. Moreover, complexity of engineering deals has increased and have become multi-year and larger in size.

* We continue to expect strong and long term traction in the ER&D market, led by increased outsourcing and market share gains by India-based players.

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