IT Sector Update : ISG Call Takeaways: Status Quo - JM Financial Institutional Securities
We hosted Namratha Dharshan, Chief Business Leader, and Sashidharan Balasundaram, Principle Analyst, of ISG for an investor interaction. They believe that a difficult macro notwithstanding, managed services demand has stayed resilient. However, they do see elongated decision cycles and pressure on discretionary spend. We believe the disconnect between healthy deal awards and weak revenue growth is explained by a) higher share of renwals in ACV (c.10ppt increase in 1H23 YoY) – implying limited incremental spend; b) unwinding of excess new scope deals – likely offsetting revenues from renewal deals; and c) slower ramp up of ITO deals. Interestingly, ISG sees growth in GCCs not as a threat but an opportunity for service providers. Recovery in XaaS (-17% YTD) and new scope deals could be lead indicators for growth revival, in our view.
Managed services - resilient: Despite the uncertain environment, Managed Services demand – led by cost optimization deals - has not fluctuated materially, as per ISG. Managed Services ACV in 2QCY23 grew by 5% YoY exceeding USD 10bn for the first time. The growth construct however has not been broad-based. Barring ADM (+22% YoY; YTD), ISG saw decline in each of Infrastructure (-8%), BPO (-31%) and ER&D (-7%). Significant investment in IT Infrastructure post pandemic has likely reduced the net new ACV here. Growth in BPO/ER&D ACV on the other hand is impacted by an unfavourable comp. Even geographically, growth has been divergent. Americas’ ACV declined (-6% YoY) for the third time in past four quarters. Pressure on BFS (-20% YoY) is pulling down growth in Americas. Growth in EMEA however has been robust driven by UK and DACH region. 280 USD 5mn+ deals, including 5 mega deals, were awarded in EMEA. ISG believes war in Europe might have triggered geographical diversification of supplier base from a BCP standpoint, aiding growth. As-a-servic
As-a-service (XaaS) remains under pressure: Impact of a difficult macro is perhaps more pronounced in XaaS. XaaS ACV was down 18% YoY in 2Q. In fact, after peaking in 1QCY22, XaaS ACV in Americas has declined in every single quarter. Infrastructure-as-a-service (IaaS) ACV declined 21.5% YoY in 1HCY23. Decline in IaaS has been across the board led by hyperscalers with Azure, AWS and GCP ACV down 20% YTD. Optimisation of already contracted capacity is likely causing the subdued deal activity.
Restructuring up; new scope down: Managed services growth has been led by renewals and expansion with second consecutive quarter of USD 4bn ACV in 2Q. New scope ACV however has been trending down. New scope ACV in Americas was down 20% YTD, reflecting downward pressure on discretionary work. Renewals share in ACV is back up to historical levels of 40%+ in 1HCY23 after a surge in new scope deals in 2021/22 pushed its share down to c.30%. ISG believes these new scope deals (awarded in 2021/22) will come for renewal in 2HCY23. ISG doesn’t see any significant pricing pressure during their renewal. We however believe, based on IT Services players’ commentary, that these Covid-era new scope deals are the ones facing scope reductions or cancellations.
GCCs not a threat to service providers: Demand for captive centres is increasing. But ISG sees this as a cyclical phenomenon. Enterprises set up GCCs for niche skills. But they typically hit a saturation level post which GCCs partner with service providers to scale them up. Even in the initial phase, setting up of a GCC requires collaboration with service providers for enterprises’ location strategy, recruitment/training of resources etc. Also, quite often, these GCCs translate into managed/shared services opportunities for the providers down the line. InfosysDanske Bank deal is a case in point.
Our view: Decline in new scope ACV’s share implies normalisation of enterprises’ IT spend. Cost optimisation led growth in restructuring/renewal deals indicate wallet share shift instead of incremental IT spend, in our view. Unwinding of excess IT spend – reflected in unusually high new scope ACV post Covid – could largely offset incremental revenues from renewals/extensions. We will monitor rebound in XaaS and new scope managed services ACV as lead indicators for service providers’ growth revival.
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