Tuesday, 16 September 2008

Lehman repercussions

The repercussions of Lehman's filing for bankruptcy protection are still being felt on stock markets today with worst hit (at least in the S/ITS sector) being the Indian SIs (TCS, Infosys, et al). Yesterday saw their stocks hammered down by up to 10% on the Mumbai exchange, but that pales in comparison to the beating they got on US markets, with Satyam’s American depository receipt (ADR) down over 14% and Patni’s down over 11%. No respite today, either, with the Mumbai stocks falling another 5-6% as we write and this likely to be amplified when US markets open later. The pain was felt on the LSE too, of course, with most of the leading UK S/ITS players losing some ground, with the notable exception of Capita, which ended yesterday over 2% higher and Morse (much smaller scale of course) up nearly 6%. Sage dropped nearly 3% and Misys – whose fortunes are most directly linked to the UK banking sector – was down nearly 5%.

As we well know, but is well worth repeating, the ramifications of a major bank failing permeate through the economy in a most insidious way. You start with the banks and other counterparties that Lehman does (did?) business with; those transactions are thrown into disarray, further reducing financial market liquidity. Then there’s Lehman’s corporate clients and its suppliers (including, of course, the IT industry), all of whom rely on the bank for business in one shape or form. Add in the thousands of highly paid Lehman’s employees about to be made redundant, removing huge spending power from consumer markets. Finally, to complete the vicious circle, the negative effect all of this has on market sentiment, bringing down stock valuations pretty much across the board, even for those companies with little direct exposure to the bank or the sector, but nonetheless reducing these companies’ ability to raise capital through their shares.

Anyone out there who still thinks a recovery is just around the corner needs to think again – seriously. These events only heighten our conviction that there is much more bad news to come from the S/ITS sector as yet another round of belt-tightening causes more 'discretionary' (and we use the term loosely) projects get deferred or shelved and CIOs become even more myopically focused on costs. It becomes self-evident that the 'winners' (relatively speaking) in the traditional IT services market will be those firms with lowest cost delivery, i.e. highest offshore capability. Software players will find themselves living off their support contracts as customers throw new licence purchases and upgrades out of touch unless their business simply can’t operate without them. Just as well Sage gets some 60% of its revenues from ‘subscription’ services, most of which are annual support contracts. Misys is not far off in terms of ‘recurring’ revenues, but is more reliant on transaction processing (17% of revenues), though 41% of sales derives from maintenance contracts.

So, ‘make do and mend’ will once again be the order of the day. This does not necessarily predicate customers will stick with their incumbent suppliers, though it has to be said that long-term relationships will clearly help. In this sense, the software players look more secure. While, say, a bank is unlikely to change its core processing software supplier or a retailer is unlikely to change its ERP platform, the ongoing (non-discretionary) application management of these systems will certainly be up for grabs, and this will favour the low-cost, large-scale, reputable suppliers. This of itself will not be enough to protect top-tier suppliers’ revenues, as pricing pressure becomes more intense and more work goes offshore at lower fee rates.

Can there really be any doubt that the UK S/ITS market will shrink in real terms next year? We don’t think so.

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