Indian IT Services: BFS Spends; Expect Volatility to Continue

Our analysis of earnings call commentaries of select US and European BFS companies indicates—(1) many BFS clients budgeted for a weak March 2019, which showed in performance of IT services firms, (2) large BFS firms expect a better business environment from April but the external environment has turned for the worse in the past few weeks and (3) overall tech spending growth will be lower than last year with additional investments funded by higher cost take-outs. Above trends correlate with the BFS commentary of IT services companies. We expect BFS to be volatile in the near term.

BFS companies had a tough start to CY2019; outlook has improved although risks remain

BFS companies in general, both in the US and in Europe, had a soft outlook for the business environment at the beginning of 2019. Increase in trade war-related concerns, uncertainty around central bank policy and interest rates, expectations of shutdown of the US government, Brexit-related uncertainty and volatility in the equity markets in December led to expectations of subdued economic activities in the ensuing months. Firms reported that although conditions were tough in January and February, the situation eased out from March leading to an improved outlook from April. The capital markets segment in particular picked up pace with better AUM flows, uptick in equity markets and improved deal activity. On balance, companies expect a more conducive environment for growth in the coming months. Key risks to outlook as reported by companies include slowdown in economic growth, escalation of trade tensions, lowering of interest rates and volatility in equity markets. The Brexit overhang is an additional risk for European firms. The escalation of trade wars in the past few weeks and the Brexit overhang can continue to weaken the modest optimism of April 2019.

Cautious outlook of BFS firms is in sharp contrast to upbeat expectations a year back

We note that BFS firms provided a radically different commentary on growth outlook at a similar period in the previous year. Companies were in an exuberant mood given a rising interest rate environment in the US. Global economic growth was strong. Corporate and investor confidence was high. Also there was little or no concern over trade wars. BFS firms increased or planned to increase investments in discretionary programs such as customer experience, data and analytics, digital platforms and mobile applications to support growth. Companies did point out that efficiencies from the run part of the business fuelled a good part of these investments. But the commentary on expense management seemed more of an afterthought, as firms were focused on capturing growth opportunities in what appeared to be a booming business environment.

Focus on expense management in light of uncertainty could have impacted tech spends

We believe that BFS companies on an average placed greater priority on cost management initiatives at the start of CY2019 as revenue visibility was low in an uncertain environment. The following extract from Morgan Stanley’s earnings call commentary aptly summarizes the sentiment of several BFS firms at the beginning of 2019.

“The fourth quarter turned out to be disappointing from a revenue perspective. We could see the decline coming. We didn't know how that turnaround would happen. The shutdown appeared imminent and then actually happened. The trade wars were heating up, it was taking down sentiments. So there was a lot of negativity building through the end of the year. And around September, October, we started taking a hard look at expenses, because you can't change the expenses once you're in the middle of the quarter. It just – it doesn't work. I mean, there's very little pure discretionary stuff you can just stop. You can stop people traveling around – going to client stuff and some, that'll save you a few million bucks. But if you are going to make a real move, you've got to be quite strategic about it.”

We believe that such planned cost-cutting measures by BFS firms could have impacted technology spends, impacting revenues of IT services companies in the March quarter. Some firms such as BoA and SunTrust reported pullback in discretionary spending on technology to cut costs. Such spends can get back on track as suggested in the earnings call extracts below

“…..(expenses were) partially offset by the timing of some tech initiative spend and marketing costs, which combined were kind of down about $200 million quarter-over-quarter. But we expect both of those to be up for the full year, as we continue to invest…”

“….(expenses were) partially offset by lower contract labor and programming cost, which is generally a function of timing and is therefore somewhat temporary.”

Companies also seem to have placed a greater emphasis on their previously planned cost-saving programs. Some companies indicated expansion in scope of such programs while some indicated acceleration in meeting savings-related goals. We note that efficiencies from automation, process optimization, etc. are components of such cost-saving programs. This could have entailed greater pressure on outsourcing companies to deliver higher productivity-related savings. We provide below extracts from commentary of State Street and Key Corp in this regard

“Given the challenging operating environment this past January, we announced an even more ambitious $350 million cost program for 2019, targeting 4% productivity savings driven by resource discipline, as well as process re-engineering and automation.”

“….(we) executed on half of our plans to reach our annual run rate target of $200 million in cost savings this year. And we expect the remaining savings to slide in by mid-year…optimized many of the support functions, implemented vendor related saving throughout the organization in a right size, the middle and back office functions…”

Shift to low-cost locations can be a key lever to manage costs for BFS firms

Some BFS firms indicated greater shift to low-cost locations to manage costs. For example, Goldman Sachs reported efforts to cut costs by migrating work to locations such as Bengaluru, Warsaw and Dallas. BNP Paribas reported transfer of some of its support functions to Arizona, a low-cost state, to control costs. In Europe, Nordea continued nearshoring to Poland and Baltics. Outsourcing can be another lever to control costs. Franklin Resources, for example, in its commentary on cost-saving initiatives referred to a possible outsourcing contract in 2020 for funds administration. The firm pointed out that increased scale of global providers and their ability to manage processes on a cost-efficient basis were key reasons for the decision to outsource.

Muted outlook for technology budgets with mix shift in favor of change-the-business

We believe that growth in technology budgets of BFS companies would be lower than 2018. Companies have indicated shift in spends from run-the-business to change-the-business initiatives. For example, JP Morgan reported that the run/change mix shift has changed to 50/50 in 2019 from 60/40 earlier. Firms have increased the pace of investments in digital platforms, mobile applications, data and analytics, artificial intelligence, cybersecurity, blockchain, etc. At the same time these investments continue to be funded by higher cost-take outs from existing IT operations through programs such as automation and cloud migration leading to flattish technology budgets overall. In our view, IT services companies with portfolio of business aligned to change-the-business initiatives can benefit when BFS firms outsource some of these spends to technology partners. On the other hand, we expect companies, which are incumbents in run-the-business spends, to face increased pressure from cost take-outs. The caveat though is that change-the-business spends have higher discretionary component and hence can be impacted/delayed in times of uncertainty. Credit Suisse, for example, puts this across as follows,“….we remain very focused on delivering consistent productivity savings across the bank and reinvesting that surplus on a measured basis depending on our assessment of economic and market conditions….”

BFS commentary of IT services companies broadly in line with our findings

Overall BFS performance of IT services companies was poor in the March quarter. CTSH was affected by continued weakness in a couple of large clients and softness in spending in a few regional banks in North America while weakness in a couple of clients in the capital markets segment dragged down performance of HCLT. LTI and Virtusa were affected by budget restructuring in Citi. Companies were also cautious in their outlook for the vertical. CTSH expected weakness in BFSI to continue in CY2019E – “We are seeing some cautiousness in the banking sector around levels of spend in the second half of the year with the moderating outlook for growth in their business.”  TCS expected weakness in a couple of large clients, especially in the capital markets segment in Europe but was confident of strong growth in the vertical. Infosys and Wipro indicated slowdown in spending of banks affected by M&A activity and leadership changes. Both the companies were confident of good growth in the vertical in FY2020E although for Wipro, growth will moderate compared to FY2019. LTI and Virtusa expected spending in Citi to normalize from 2QFY20. Hexaware gave a weak outlook for CY2020E – “We're seeing higher gestation periods for decision making. So we do expect that kind of a view to continue a little bit of wait and watch in BFS and it is slightly weaker now than we anticipated at the beginning of the year.”

We believe that BFS underperformance could be explained by reduction/delay in discretionary spends and/or increase in intensity of cost take-outs by BFS firms as discussed earlier in the note. M&A activity in a few banks such as SunTrust and BB&T could have also impacted spending. Cautious outlook of IT services companies for BFS ties in with similar outlook of BFS companies themselves.

We expect volatility in technology spends of BFS companies

Given the uncertainties in the macro environment and volatility in equity markets, we expect cautious outlook for the vertical to continue in the near term. Technology spends depend on budgetary decisions, which in turn depend on outlook of the revenue environment. In this regard, we expect technology spends of BFS firms to be volatile in the near term.