Information Services Group, Inc. (III) Earnings Call Transcript & Summary

Welcome to the Third Quarter 2023 ISG Global Index Call. I'm Sumeet Jain, Vice President at ICICI Securities covering technology sector. And I'd like to thank the team at ISG for their valued work on the industry and for asking us at ICIC Securities to introduce this call today. ISG has been hosting these index calls on the IT and business services sector for more than 20 years. ISG regularly advises over $12 billion of total contract value each year, giving them deep insights into the sector as well as the key changes in enterprise demand. With that, I will turn the call over to Stanton Jones, distinguished analyst at ISG. Over to you, Stanton.

Thanks, Sumeet, and hi, everyone. With me today is Steve Hall, Partner and President of ISG EMEA; Kathy Rudy, Chief Data and Analytics Officer; Namratha Dharshan, Chief Business Leader for ISG India and distinguished analysts, Alex Bakker. This is our 84th consecutive index call. So whether you've been joining us for many years or are new to today's call, thank you for investing some of your time with us today as we give you ISG's point of view on the health and the growth of the IT and business services sector. Steve, I'll turn it over to you for a recap on the big three thoughts from the quarter.

Great. Well, thanks, Stanton. It's been an exciting Q3 for sure. Let me go through the first -- the big three. First of all, managed services demand remained strong. We saw nine mega deals awarded in the quarter and really just a surge of midsized deals. We continue to see really strong demand for cost optimization, both in the awards ISG's advising and in the broader market. The second big thought is interest in global capability centers continue to grow as enterprises are increasingly using local operating models to build internal capabilities, balance their need for talent and address core cost pressures. Alex will discuss some great insights from some research we just completed. Finally, we're starting to see the impact of generative AI as providers propose dramatic productivity improvements across applications, IT operations, customer experience and business automation. Again, we just completed a detailed analysis of the enterprise G&A use cases that capture the exciting investments in this space. Let's take a few minutes now to go through the global markets. Despite a record-setting managed services ACV, the combined market was flat quarter-over-quarter, down 7% on a year-to-year basis and down almost 12% from its peak of $26 billion in the first quarter of 2022. The managed services ACV though reached a record high of $10 billion for the second consecutive quarter, continuing the strength of growth in 10 out of the 11 last quarters. We sold over 650 contracts, including nine mega deals awarded this quarter and growth was really driven by strength in the energy and health care sectors. The managed services market is on pace to deliver over $40 billion of ACV this year. Over 2,000 contracts and $30.3 billion of ACV has already been awarded year-to-date, which is up 6%. The total ACV of deals between $30 million and $60 million was up over 65% year-over-year, with over $5 billion of ACV awarded in this range. Disappointing news is really the as-a-service market. We continue to see some weakness in cloud spend, which was down 2% quarter-over-quarter and down 15.5% year-to-date. But as a service market at $12.8 billion, has been down now for 6 consecutive quarters from its high of over $16.8 billion in the first quarter of 2022. So let's delve into some of the major insights from the quarter. Alex, I'm excited about the GCC market and what's happening there. Can you share your insights?

Thanks, Steve. For the last two index calls, we've been continually discussing the unprecedented interest in Global Capability Centers or GCCs. We've heard both interest from service providers in purchasing or helping clients monetize their GCCs. And interest from clients in setting up or expanding them in about equal quantities. A recent study done by ISG Research on over 300 large enterprises has validated this dual trend of clients either divesting or growing their GCCs. Interestingly, the motivations for either decisions seem to be about the same. In the study, enterprises that indicated they were expanding their GCCs, we're focused on achieving cost savings through access to localities with lower labor rates. And moreover, we're focused on the availability of talent in the geographies where they had built GCCs already. Conversely, those who are facing challenges with their GCCs and looking to divest or monetize them were facing employee attrition and difficult talent environments, and we're struggling to manage the operating cost and complexity. To see cost and talent driving demand on the GCC market is not surprising. But to see these driving decisions in both directions speak to the complexity of the market right now. So to try to bring some clarity to this, we've segmented the enterprises into three GCC archetypes, as you can see here. The first archetype has been focused on solving the talent side of the equation. Overwhelmingly, they have achieved their cost targets, but their quality and satisfaction metrics have declined significantly as a result. And over the next 24 months, they are planning on reducing staff. This is the group we believe are focused on monetizing their GCCs. The second archetype was driven more by value than by access to talent. And they predominantly built their captives in alliance with service providers using a build-to-operate transfer model. This group has many more captive centers on average, and we're working to reduce locations. Unlike the first group, they were seeing moderate gains in all the performance areas we measured. This group represents an opportunity for providers who can help their customers consolidate multinational operations into low-cost countries. Finally, the third archetype was also driven by value like archetype 2, but originated their captives from managed services contracts that were converted to captives after the fact. They were performing the best in all the self-reported metrics of any of the three archetype we found. And their focus for both the last 2 years and the next 2 years is to expand staffing at these locations. Ultimately, creating a global capability center is just one component of a much larger conversation about risk, cost, service delivery management and strategy realization. So providers that can help their clients work through these factors and stay flexible on both delivery and commercial models, we think are set to gain an advantage in this talent constrained and cost-conscious environment. With that, I'll turn it over to Namrata to talk about the emergence of generative AI.

Thank you, Alex. Since our last index call, we began reporting on emerging impact and investments in GenAI use cases. We launched a detailed market study to analyze the rapid evolution of use cases in the enterprise. With this, GenAI has grown beyond high and has already become a priority investment area. According to a recent study on future workplace, 85% of the enterprises believe that investments in generative AI technology is important or critical. Not to mention the adoption and maturity of these use cases, we conducted a deep time research to better understand the GenAI use cases and its adoption. In our recently launched state of applied generative AI market report, we see increased demonstration of functional use cases and vertical use cases. While there are several functional use cases maturing and impacting various business functions, one of the areas is application development and maintenance. The majority of the use cases in cogeneration is high in terms of delivering the potential ROI. Now on the other hand, vertical use cases are growing faster, including adoption. However, the adoption varies significantly amongst various industries. For example, BFSI it leads the charts in terms of both mature use cases and adoption. Whereas in other verticals such as manufacturing and health care, they're still in ideation phase and are still being developed. Now turning to see how enterprises are embracing this change, enterprise focus on GenAI has significantly increased and their willingness to experiment or work on PRC is high despite the uncertainties, the security concerns the ROI and data quality, et cetera. Enterprises are also increasingly leaning on their service providers to actively partner and identify areas of applications. On the other hand, providers are actively investing in building solutions and are proactively collaborating with enterprises to co-create solutions. They must also focused on potential ROI and articulate the viability of these applications. So enterprises are much more confident in investing. Now while ROI is one of the biggest concerns, there are other concerns that the providers must also address like ethical concerns, security, encourage enterprises to focus on managing legacy data and other legal consults. So while we are seeing strong interest in GenAI from enterprises and a growing number of use cases from providers, what's missing here to really accelerate AI adoption is what we are calling a business architecture, basically a reference model on what a good enterprise AI strategy should look like. These kind of models are really important anytime a new technology emerges. We saw this with cloud. Now we are seeing it with AI, with that, Stanton, I'll turn this over to you for an update on Managed Services demand.

Thanks, Namratha. As Steve mentioned, demand for managed services continues to be very strong, and that's especially true for IT outsourcing. The ITO market had its best quarter ever in the third quarter. And on a year-to-date basis, ITO was up 14% year-to-date. And that's on the back of the most ever contract value and awards through the first three quarters. And on a regional basis, most of that ITO growth came from the Americas and Asia Pacific, while EMEA was up slightly. Within ITO applications continue to drive the lion's share of the growth with ACV up 24% year-to-date, 65% of ITO ACV is now coming from applications outsourcing. So essentially, what that means is that over the last several years, we've moved from an infrastructure-centric sector to an application-centric sector. BPO on the other hand, was down 12% year-to-date, driven by a double-digit decline in the Americas. And within BPO, industry-specific BPO had its second best year-to-date result ever, but given how strong 2022 was for vertical BPO, it's down almost 25% year-to-date, as you can see here. Another one of the big growth drivers of BPO engineering was also down year-to-date, but we think some of this is due to the downward pressure on discretionary spending that we've been discussing over the past few quarters. But it's important to keep in mind that outsourcing penetration in engineering is still quite low, and we think it still remains an enormous opportunity for service providers in this space. As Steve mentioned earlier, mega deals or deals with $100 million of ACV or more have driven a lot of the strong managed services results through the first 3 quarters of the year. As we said earlier, there were nine mega deals awarded this quarter and year-to-date, there have been 27 mega awards. That's the most through 3 quarters since all the way back in 2014. Those 27 awards have generated nearly $5 billion of ACV. And to give you a sense of the impact of that, if you compare this year to last year, that's around $2 billion of incremental ACV coming from mega deals. So you can start to see the kind of impact that these large deals are having on the IT services sector. Mega deals continue to be shaped through incumbency, consolidation and spin-off of GCC. And in fact, we actually just wrapped up some interesting new mega deal research and found a strong correlation between long-term incumbency and mega deal win rates. And we'll be writing more on this red hot topic on the weekly insider, so keep an eye out for that. Okay. Kathy, over to you for an update on the regions?

Let's start with the Americas. The Americas region had its best quarter ever in Q3, with nearly $6 billion in ACV. On a year-to-date basis, managed services in the Americas also set a new record of $15.7 billion, up 6.3%. There was a noticeable uptick in mega deals, as Stan has mentioned, with 13 awarded in 2023 compared to seven in 2022. This stands as the highest 9-month performance from mega deal since 2010. Significantly, the ACV resulting from these mega deals surged by 50% from the previous year, contributing an extra $650 million to the market. Industry-wise, in the Americas for the first 9 months of 2023, energy, health care, pharma and telco media sectors achieved record highs in ACP experiencing substantial growth year-to-date. However, financial services recorded a dip of 12% year-to-date and manufacturing decreased by 9% year-to-date. Moving to EMEA. After achieving a record performance in Managed Services in the previous quarter, performance returned to 2021 levels with ACV of $3.7 billion, a 2% decline year-on-year. For 2023 year-to-date, managed services in EMEA reported an ACV of nearly $12 billion. That's a growth of 2.4% compared to 2022. While the mega deal count for the year stands at [ 10 ], just one shy of 2022's total, the value of those mega deals has surged by 55%. From a market perspective, year-to-date, the financial services is up 14%, with energy sector also up 36%. In contrast, manufacturing and travel and transportation, decreased by 14% and 23%, respectively. Regionally, the U.K. stands out with three consecutive quarters, each exceeding $1 billion in ACV, resulting in a year-to-date jump of 49% compared to 2022. The DACH and France markets face challenges, both seeing a 25% drop year-to-date. Let's take a look at APAC. In APAC, for the third quarter, the managed services market recorded an ACV of $651 million. This is the first time in a year that ACV dipped below $800 million, with two of the past three quarters, exceeded the $1 billion ACV mark. Despite the overall decline, new scope activity in the third quarter shows an increase of 28% year-on-year. For 2023 year-to-date, the managed services sector had an ACV of $2.6 billion. That's reflecting a growth of 25% compared to 2022, a record not seen since 2012. By industry year-to-date, manufacturing showed triple-digit gains in telco and media rate -- both rose by 74% and financial services dropped by 14%. Geographically, there were varied outcomes within Asia. ANZ, the region's largest market, had ACV growth of 54% year-to-date and India, the second largest was up nearly 100%. However, smaller, yet significant markets such as Japan and Southeast Asia, face moderate reductions year-to-date. Now let's look at managed services from an industry perspective, given how big and how important the BFS sector is to the IT services sector, we're going to focus on this industry this quarter. As you can see here, BFS is down across every category year-to-date, combined market, managed service and as a service. But for today, we're going to focus specifically on managed services, which is down 3% year-to-date. And while 3% decrease may seem modest, it has significant implications on the entire managed services market because historically, it's 30% of all of the ACV in the market. To show you what kind of impact BFS has on the overall market, if BFS were flat instead of down 3%, an additional $300 million of ACV would have been added to the managed services market. Which in turn, we should have increased overall market spend growth from 6% to 7%. Now in the past, the Federal Reserve interest rate hikes have impacted tech spending in BFS. For example, between 2004 and 2006, Fed rate hikes preceded a major economic downturn and BFS sector's ACV reduced by 10% in 2008. However, we do see a silver lining in that the current rate hike cycle may be nearing its end with a potential easing of race by the Fed in 2024. If this happens, especially in the first half of 2024, we could see renewed growth in BFS, which in turn would spur significant growth in the overall managed services market. Now I'd like to turn you back over to Stanton to give you an update on cloud demand.

Thanks, Kathy. As we've talked about extensively over the past year or so, Infrastructure as a Service bookings continue to be under a lot of pressure. As you can see here, year-to-date bookings for IAS are down almost 20% versus 2022. And this is the only 9-month decline we've seen for Infrastructure as a Service since we started reporting on the segment back in 2015. And regionally, it was pretty much the same story. EMEA was down 15%, and both Asia Pacific and the Americas were down by 20%. The big three U.S. hyperscalers saw bookings decline by even more than the overall IAS basket. They declined 22%, as you can see here. But it's important to keep in mind that this is part of a general downtrend in Infrastructure as a Service that's really impacted all three providers evenly, and it's not really an indication of something company-specific. And given that the big three have over 65% of the market share of our Infrastructure as a Service basket, that means it will likely be one or two more quarters before we start to see the bottom of the cycle for Infrastructure as a Service. That said, we still see significant demand happening around cloud, especially around application modernization. But much of this work is being done within the context of existing framework agreements many of which are coming up for renewal in 2024. So we'll be watching this closely. Okay. Let's move on to Software as a Service. Year-to-date, the SaaS segment produced $11.5 billion of ACV and that was down 6% versus 2022. And However, unlike Infrastructure as a Service, with SaaS, we think we may already be at the bottom of the negative cycle. And that's because of what's happening within the top 10 SaaS providers and what's happening with each SaaS category. The top 10 SaaS providers actually grew bookings by 7% year-to-date, and we continue to see enterprises favoring platform-based consolidation as opposed to best of breed. And when you look at the SaaS categories shown here on the right-hand side of the chart, you can see that most of them saw negative year-to-date growth. But if you look at the quarterly results, areas like collaboration, content management and ERP were all up year-over-year. So it's the combination of these two factors that signals that SaaS has likely bottomed out. And if that's the case, it's likely to have a beneficial knock-on effect for the systems integration practices for many IT service providers. Okay. Namratha, back over to you to take us through the provider leaderboards.

Thank you, Stanton. As a reminder, providers are listed in alphabetical order and positioning is based on annual contract value signed over the past 12 months. The company is new to the list are denoted with an asterisk and also a reminder that the regional leaderboards can be accessed on the ISG website. The trend continues as we saw very little turnover in the Big 15 leaderboard, One new addition to the Big 15 is Kyndryl, which won a variety of contracts at Canara Bank in India, Telefonica de Argentina and Care New England a deal that ISG broker. The real story this quarter was the view of mega deal signings focusing on cost takeout by many in this group. HCL Tech closed a deal with Verizon business as a managed network services collaborator. TCS will deliver a broad range of services to the digital unit of JLL. Liberty Global will outsource the development and operation of the Horizon and entertainment platform to Infosys. And Cognizant signed an IT infrastructure deal with Gilead Sciences. The Building 15 added a couple of new firms, Computacenter joined due to several large awards in the dark market, and Capita made the cut with wins from customer experience renewals at Virgin Media O2 and the BPO deal at Student Loans company. In the Breakthrough 15, Coforge moved up a category Mphasis rejoined after being particularly active in the BFSI space. Turning to the Booming 15 who were unusually quiet, two slots turned over, CSG joined based on a large extension with Comcast, and HGS came back this quarter. And that now Steve, back over to you to close us out on the forecast.

Alex and Namratha, thank you for the insights on the rise of GCC and for clarifying the amazing growth driven by GenAI. This research is really groundbreaking and will help our clients make important decisions. The managed services market remained robust in Q3 despite economic headwinds and concerns. The managed services industry has now seen three consecutive quarters at almost $10 billion of ACV. There were nine mega deals awarded in Q3, bringing the total for 2023 to 27 mega deals worth more than $4.8 billion. More importantly, we saw a strong volume of deals across all ACV bands. We continue to see strong growth across the globe. And as you may recall, EMEA was the growth leader in Q2 and the Americas had a record break in Q3. Year-to-date, the managed services market is up over 6% compared to 2022, even with the BFSI sector down 3% year-to-date. The as-a-service market dropped 15.5% year-to-date, apparently based on weak bookings with the major cloud providers. The Big 3 hyperscalers continue to see a decline in bookings the China-based hyperscalers are past the higher compares and a decent fourth quarter could potentially leave them flat for 2023. The SaaS segment grew by 8% last quarter and with several major segments within this group really gaining momentum. From a macroeconomic perspective, we've seen modest improvements in decision-making and increased spend. The global interest rates remain high and concerns persist with energy prices, a strong dollar and the expectation of a prolonged period of higher interest rates. As Kathy mentioned, this could result in additional headwinds for Capped spend and the Managed Services segment. Clients continue to restructure their IT landscape, though, to adopt the multi-cloud environments hybrid work durations and are beginning to experiment with GenAI enterprise drag use cases. We expect the applications market to continue to expand in 2024 as well. Given the strength of the managed services market, we're improving the full year growth in the managed services sector to 5.4%, up 40 basis points. These adjustments reflect the strength of Q3 and the overall focus on cost optimization at the enterprise level. Q4 is typically a stronger quarter for the managed services market. Since 2000, there's only been 4 times where Q4 generated less ACV than Q3, and it's only happened once in the last 10 years. The as-a-service situation is a bit trickier, but the SaaS market is returning, cloud is still under pressure. Therefore, we are leaving our forecast at 11.5% growth for the year. So that brings us to the end of the formal call. We'll now open it up for questions. Please type your questions and comments to the right of the screen. And Sumeet, would you like to start the questions?

Yes. Surely, Steve. Firstly, thanks a lot for that insightful presentation. Clearly, a lot of takeaways for everyone. So maybe firstly, I would just like to talk about on the demand side. Clearly, we are seeing a lot of pressure on the discretionary side in terms of rationalization of tech spending, particularly after 2 years of very strong demand post the pandemic. And of course, I think there is a self-limiting factor to the extent of rationalization. So I just wanted to understand if the macro continues to remain tough in calendar '24 as well given the geopolitical risks we are seeing the oil prices, continued high inflation and maybe higher interest rate [give] as well. How do you see this self-limiting factor of rationalization of tech spending playing out? Particularly in the second half of calendar '24. I know, I mean, it's like predicting something which is 6 to 9 months down the line, and it's slightly more difficult. But based upon your past experience, how long this cycle can continue around rationalization of discretionary demand.

Stan, do you want me to take that one?

Yes, go ahead, Steve.

Yes, absolutely. So again, thank you, Sumeet, for joining. On the demand side, you're right, it is a bit hard to predict going in over the next 9 months. In general, we still do see a pullback on discretionary spend. I think it's been consistent for the last sort of two to three quarters. Someone told me recently, I think we're in the most talk about nonrecession ever, but that really means that organizations are being cautious on how they allocate dollars. But there's also a lot of high expectations that I think are out there on the discretionary side. We talk about GenAI in almost every conversation, but that's an exciting thing for organizations as well as they think about how do they reimagine their customer experience, how do they reimagine their products and services. We're still in the early innings, quite frankly, on digital transformation, and there's a lot of activity as the markets mature around that. So I think there is a pent-up demand on those organizations to release some of that. But until there's probably a better picture on the financial front and the broader economic front, it's probably not going to hold. So just thinking through the market, and we've talked a lot about this over the last couple of weeks, I would be cautious going in on the overall tech spend increasing over the next three quarters. I think we're probably looking at early May, June time frame before we see really opening up. I think managed services is going to continue to remain healthy, really driven by the cost optimization and all the new operating models that we've talked through. But that discretionary spend, which for a lot of us is a bigger part, is going to continue to cause some headwinds for most of the big SIs in the market.

Yes. And Sumeet, I wanted to add on the discretionary spending side, I know you and Steve have talked about this prior to the call. I think it's also important to note the impact the discretionary spending can have on applications-related outsourcing. So that's really what's driving most of the ITO growth that's over, what, 65% of the ITO of the ACV now is applications. You could have in a contract, you could have 20% to 30% of that contract be viewed as discretionary versus run, so that's also kind of holding back. You could argue holding back some of that ADM spending as well.

Got it. No, that's very helpful. And on the demand side, I guess, in terms of your forecast, particularly for other services, ACV up 11.5% for the entire year. That implies a very strong Y-o-Y growth in the fourth quarter. So are you expecting some budget flush out there or any significant activity on the as a services side?

Yes. The activity looks strong, Sumeet. So you're right, when we build up the forecast, we really take a look at the pipeline all the way through. We look at the macro environment. We look at the strength of that we actually break it down by vertical and country to pull it together. So we raised it, the 40 basis points to 5.4%, really based on strong demand that we see across assuming that we get we're accurate, we should see another $10 billion-plus quarter of ACV. It should put us up in the over $40 billion of ACV for the year, which would be right around the growth rates that we see. As I mentioned, we've never -- in the 20 years, we've only seen 4x where Q4 was lower than Q3. And I think the demand environment right now, especially for the managed services remains strong. So I don't want to say we're bullish because of some of the demand concerns that we've had, but I think we're very optimistic that it's going to be a strong year on the managed services side.

Right, right, Steve. So actually, my question was more around the -- on the as a services side.

Stan, you want to take the asset service question? .

Yes, Sumeet. So the -- as we talked about, I would say that's probably more a reflection of the fact that we're starting to -- some of these sectors are starting to kind of roll over. rather than necessarily a lot of new discretionary spending coming into cloud. So you can start to see that as we talked about in some of those SaaS segments. So for example, an ERP and HCM, some of those are now up quarter-over-quarter, not year-to-date but quarter-over-quarter. So that's an indication to us that we're -- essentially, the compares are getting easier. Not necessarily that we're seeing incremental budget being flushed or net new spending around there. And I did want to make it clear that we still see a significant amount of cloud activity happening. And I see some questions coming in around this. It's just the pullback on bookings there, both -- it's kind of different for Infrastructure as-a-service versus Software as-a-service. As we've talked about on the Infrastructure-as-a-service side, that's more a reflection of enterprises buying a lot post pandemic and using what they already thought. On the Software as a Service side, that's in our view, more of an impact of this pullback on discretionary spending, let's delay the upgrade or let's just roll out this portion to this unit and not the entire company. So the pullback on the SaaS bookings are -- sorry, the cloud bookings are for a little bit different reasons, but we are starting to see some green shoots, as I mentioned, on the SaaS side and specific categories.

Got it. Got it. No, that's helpful. And then you had a good section around on the captive side in India. And we are clearly seeing a lot of Fortune 500, G2000 customers are pressing to open up their own captives in India, based on what the learnings they had during the pandemic. I just wanted to understand the follow-on impact of that on IT services industry. Do you think it's a market taken away from them by the captives? Or do you think it's an incremental revenue opportunity for them by working alongside captives over the next several years? How do you see these cycles playing out?

Alex, do you want to that?

Sure. I think that from the data we have in the recent study, I think, is an incremental opportunity for the service providers. Overwhelmingly, the demand for captive is kind of driven by demand for talent. And in the data, we see a consistent need for help hiring, help doing process reengineering help automating processes. And I see a lot of opportunity for the providers in helping to actually leverage their superior hiring engines versus what many enterprises without the name recognition in the India market being achieved by themselves.

I think there's one other piece that's really important here. We used to call them bots or captive JVs, different things. I don't think the bots that build operate transfer are necessarily above again. But we are seeing a lot of what I would call hybrid captives where the service provider and the enterprise client really work together to make a better solution and offering. So I think that's going to be growth for the overall market as you see it. And I know there's multiple SIs that are really helping clients in this space. It can even be within their campus. Think about what we used to do with ODCs or offshore development centers, they bring in legal, HR, talent, their management expertise, tooling, et cetera. That you use more client personnel, et cetera, to do it. So I think it's going to be a net win for it. It's still sort of the recognition that we live in a global talent pool. And we have to go after the best talent in the world regardless of where things sit.

Right, right, right. And maybe one last question around the generative AI. I mean, of course, we have seen a lot of the use cases getting developed and you have talked about fairly deeply in terms of some of the impact on the industry. I just wanted to understand in terms of the financial impact of this on the IT services providers from the revenue perspective or from the margin perspective, how far do you think that will start getting reflected in their financials? And what will be the impact for the revenues or the margins in your view?