With the dominance of IT spend (whether consulting or outsourcing) in many of today's investment theses, Morgan Stanley's new forward-looking models should have more than a few long-only money managers rocking quietly in the corner of the office (especially given IBM's dominance of the Dow). Their proprietary models (discussed below) predict decelerating revenues in both consulting and outsourcing through Q2 2013 reflecting the weak discretionary spend environment. The inflection in outsourcing is particularly notable and is far from priced in with the velocity of the fall suggesting 2009-like cutbacks. After the last recession's drop, IT outsourcing was a key area of cost reduction that also provided additional revenues for a new sector; one has to wonder if the recovery this time would be so acute (since sooner rather than later the cutting of fat leads to lascerations in the muscle).
Via Morgan Stanley:
IT Outsourcing Leading Indicator Model (MSOSLI)
Similar to Consulting, the MSOSLI model enjoys a very high R-squared (0.96). The model also uses three macro economic indicators and two company-specific metrics, including:
- Change in Euro Area Consumer Confidence
- Change in Durable Goods Unfilled Orders
- S&P 500 Composite One-Year Return
- Change in CapGemini Consulting Headcount
- Change in Accenture Outsourcing Headcount
A summary of these factors along with their statistical measures from the univariate regressions performed in the model construction phase (see below) is shown in Exhibit 7.
LTM Outsourcing average revenue growth accelerated in 3Q10, at +0.4% growth, and peaked in 2Q12 at +5.2% growth. MSOSLI forecasts a deceleration beyond 2Q12 with forward four-quarter revenue growth (through 2Q13) estimated at +1.0% (excluding ~25bps of bias).
Recent Accenture and IBM commentary suggest this trend is beginning to materialize, for example:
- Accenture’s constant currency growth remained strong in F4Q12 (+18% vs. +19% in F3Q12 and +20% in F2Q12). That said, management noted that it remains vigilant about understanding the impact of the evolving global macroeconomic environment. Plus, management’s expectation for 5-8% cc growth in FY13 (vs. +11% in FY12) embeds a slower than anticipated market growth (+4.8% vs. +5.6% previously) with the Technology/Outsourcing segment lower by roughly 100bps vs. the previous estimate.
- IBM GTS 3Q12 revenue grew +1% cc (vs. +2% in 2Q12 and +3% in 1Q12). Management noted that while IBM generated revenue growth from its backlog in 3Q12, it did see a decline in revenue generated from new business in existing accounts and from new deals within the quarter, after growing through the first half. Unlike Consulting, backlog (flat cc) and signings (+30% cc) appeared somewhat stronger in 3Q12 although management did say that going forward it expects a similar IT Services revenue growth dynamics.
- At HP’s analyst day in early October, management noted that a runoff of four key clients is pressuring Outsourcing revenue. While some of HP’s issues may be company-specific, an overall trend toward in-sourcing is worrisome. For example, we know that GM, one of the four clients, which spent an est. $600m with HP annually (~2% of HP’s Services sales) has decided to bring much of its IT work in-house.
- For Atos, Outsourcing revenue growth was +1% on an organic cc basis in 3Q12. This is down from +2% in 2Q12 and +4% in 1Q12, which suggests a downwards trend. We believe the recent Managed Services contract wins at Atos and other deals in the pipeline (e.g. McGraw-Hill) will help the company perform above competitors if the market trends down into 2013.
In light of the continued deceleration predicted by our leading indicator models, we lower our top-line growth expectations across the global IT Services industry.
Source: Morgan Stanley