Most of the companies I track in the industry did indeed meet previously reduced earnings guidance, but most also indicated that growth in the third quarter will probably be lower than it was in the second quarter.
The IT services industry is a good one to monitor for clues to IT spending; the participants tend to acquire and use a wide range of hardware and software from other companies to build information systems for corporate clients, as well as providing custom software development services.
For the industry in general, the larger integrators, including Electronic Data Systems and IBM Global Services, will continue to show sequential revenue and earnings growth as their global diversification and long-term outsourcing contracts offset the weakness in their relatively small (for them) shorter-term systems integration and consulting businesses. However, I expect sequential quarterly revenue declines for many of the mid-tier integrators (around a billion dollars or so in revenues, including companies such as American Management Systems and Keane.)
Also, over the next quarter, expect sequential declines in revenues for even large consulting companies such as Accenture and KPMG Consulting. Unfortunately, layoffs in the industry will likely continue over the next quarter, though probably at a lesser rate than in the first two quarters of the year.
Most of the e-business companies should continue to show sharp 20 percent to 30 percent sequential declines in revenues in the next quarter, as larger companies continue to take back market share from these smaller players. Of course, these companies no longer describe themselves as e-business companies.
One of the largest companies in this segment, Sapient, is actually turning to more boring, but stable, IT services such as application outsourcing and offshore development in India.
What does this outlook likely mean for the industry over the next year? Consolidation. Growth in the industry has been quite high over the last few years due to the rush of IT spending around Y2K from the mid-'90s to 1999, both replacing and fixing information systems, followed by the Internet boom.
Now, unlike other slowdowns in recent history, there is not an apparent major catalyst for IT spending on the horizon--no Y2K, no Internet. The catalyst is expected to be a rebound in general business expansion, and prospects for a rebounding economy now seem to be pushed out to mid-2002.
However, shareholders are not going to wait until mid-2002 for growth, and will likely pressure companies to acquire the growth. Many of the public IT service firms had stock offerings over the past few years--resulting in no debt and plenty of cash--in what should be a positive cash-flow business, giving these companies the ammunition to acquire even in a tough stock market. Even the larger IT service firms, such as Electronic Data Systems, Computer Sciences Corporation and Affiliated Computer Services, have been able to access the debt markets this year to pay for acquisitions.
Also, there is a new group of large, motivated buyers in the industry, including Compaq Computer and its new merger partner, Hewlett-Packard, and other hardware and software companies looking to boost their IT services capabilities. In fact, at a recent analyst meeting, Compaq indicated it wants its services unit, Compaq Global Services to grow from 23 percent of Compaq revenue in the second quarter (about $1.9 billion), to one-third of revenues. Compaq's emphasis confirms the trend of larger technology companies' expanding their services offering--following the success of IBM Global Services--and seeking to increase their client penetration by leveraging their installed base and providing a single point of contact.
I also expect the commercial e-business companies to consolidate, though with little investor interest given their relatively small-market capitalizations. For example, two past leaders in this space, Scient and iXL Enterprises, both of which have been experiencing dramatic sequential revenue declines, recently announced they would merge, only to have their combined market capitalization decline from $134 million to $66 million in the weeks after the announcement.
Right now, it looks as if the next couple of quarters will be even more difficult for the IT services industry than the first two of the year were. But I believe the stronger players will continue to grow through smart acquisitions.
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William R. Loomis is a managing director covering the information technology services industry at Legg Mason's equity research department. He also is a chartered financial analyst, and is a member of both the Baltimore Security Analyst Society and the Association for Investment Management Research.