IT Services Growth potential remains robust Recommend Overweight; Large players to display differentiated growth We present an Overweight rating on the IT services sector in light of the strong Overweight (Maintain) quantitative and qualitative growth outlooks for large IT service providers. Indeed, we note that major corporate groups are expanding IT investments in areas including cloud computing, smart factories, AI, and Big Data. On the back of stable orders from Industry Report affiliates, IT services firms belonging to large corporate groups are expected to April 11, 2019 maintain double-digit top-line growth this year. Enjoying both stability and growth potential, the IT services sector should provide attractive investment opportunities. • Top-down: Earnings stability to improve on declining economic sensitivity Mirae Asset Daewoo Co., Ltd. The IT services industry tends to display high sensitivity to economic conditions, with [Conglomerates/Software] orders moving closely in line with customers’ capex. However, as IT spending is increasingly being viewed as essential to survival, the industry’s economic sensitivity is Dae-ro Jeong declining steadily. +822-3774-1634 [email protected] • Bottom-up: Earnings growth based on captive demand Large IT service providers affiliated with corporate groups (conglomerates) are expected to maintain steady revenue growth based on captive demand from affiliates. Most of them are the exclusive providers of IT services to affiliates, as they are better positioned (vs. external competitors) to ensure group-level security and swiftly respond to unexpected events. We forecast that large IT service firms will display differentiated growth going forward. Indeed, their scale and market positioning have given them the upper hand in: 1) building up strong and diversified track records; 2) accumulating experience in managing a technical workforce and relevant projects; 3) strengthening capital power; and 4) increasingly winning the favor of customers. Such competitive advantages should further improve the prospects of their business expansion efforts and overseas projects. Top picks: Samsung SDS and Lotte Data Communication * Samsung SDS (018260 KS/Buy/TP: W290,000/CP: W233,500): Increased revenue contributions from strategic businesses; additional growth via M&As - Revenue contributions from strategic businesses, including smart factories and cloud computing, are anticipated to rise to 33% in 2019 from 30% in 2018. - The company will aggressively use its cash holdings (W3.6tr) to pursue M&As and secure additional growth drivers. * Lotte Data Communication (286940 KS/Buy/TP: W63,000/CP: W48,300; initiate): Expecting 10% CAGR through 2025 - The Lotte Group plans to make W50tr in investments by 2023, which should benefit the company by boosting demand for IT services. - Margin growth is expected to accelerate thanks to an increasing mix of high- margin projects and a steady rise in software engineer service fees. Increasing IT investments by group affiliates to drive growth potential of large IT service providers (Wtr) Revenue (L) Affiliate revenue contribution (R) (%) 10 100 8 80 6 60 4 40 2 20 0 0 Note: Based on consolidated 2017 financial statements Source: DART, Mirae Asset Daewoo Research Analysts who prepared this report are registered as research analysts in Korea but not in any other jurisdiction, including the U.S. PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES & DISCLAIMERS IN APPENDIX 1 AT THE END OF REPORT. April 11, 2019 IT Services C O N T E N T S Key charts 3 Analysis of the IT services industry 4 1. Industry structure 4 2. 2019 market outlook 5 3. Investment points 6 Issues 9 1. Impact of related-party transaction regulations to be limited 9 2. Public projects are increasingly being opened up to large IT service providers 11 Samsung SDS (018260 KS) 12 Lotte Data Communication (286940 KS) 18 Mirae Asset Daewoo Research 2 April 11, 2019 IT Services Key charts Figure 1. Major countries’ markets for IT services (2018) Figure 2. IT investments as % of revenue (US$bn) (%) 3.3% 56.5 600 Market size (L) 60 Contribution to global market (R) 500 50 400 40 300 30 200 20 0.6% 6.6 8.0 100 4.2 10 1.2 0 0 Korea China Germany Japan US Domestic Global Source: Gartner, KRG, Mirae Asset Daewoo Research Source: KRG, Deloitte, Mirae Asset Daewoo Research Figure 3. Major IT service firms’ revenue and revenue Figure 4. Major domestic IT service firms’ M/S contributions from group affiliates (Wtr) (%) Revenue (L) Affiliate revenue contribution (R) Lotte Data 10 100 POSCO ICT Asiana IDT 4.0 Communication 1.1 3.5 Hyundai 8 80 AutoEver 6.2 6 60 SK C&C Samsung SDS 6.5 38.9 4 40 2 20 LG CNS 12.6 0 0 Other 27.3 Note: Based on consolidated 2017 financial statements Note: Based on consolidated 2017 financial statements Source: DART, Mirae Asset Daewoo Research Source: DART, Mirae Asset Daewoo Research Figure 5. Samsung SDS’s cash and equivalents Figure 6. Lotte Data Communication’s cash and equivalents (Wtr) (Wbn) 5 250 Cash and equivalents IPO capital 4.3 4 3.7 200 2.9 127.7 3 150 2.5 2.0 2 1.7 100 1.1 1 0.8 50 86.1 91.5 0 0 12 13 14 15 16 17 18 19F 17 18 Source: DART, Mirae Asset Daewoo Research Source: DART, Mirae Asset Daewoo Research Mirae Asset Daewoo Research 3 April 11, 2019 IT Services Analysis of the IT services industry 1. Industry structure IT service firms provides customers with a wide array of solutions, including consulting, demand analysis, system design, system component development, system integration testing/deployment, and system management/maintenance. Broadly speaking, IT services are largely divided between system integration (SI) and system management (SM; outsourcing). SI providers design, develop, administer, and manage IT systems. The scope of SI services includes system design, hardware selection, order placement, procurement, application software development, and maintenance. Notably, actual system buildout can be executed by a consortium of SI firms specialized in different areas, and software development can be outsourced. SM providers manage and operate equipment, human resources, and hardware related to customers’ IT systems on an outsourced basis. The scope of SM services includes the operation and management of data centers, network outsourcing services (administration and management of network infrastructure), application services (new IT system development and operation), desktop services (from PC purchase to disposal), disaster recovery (minimization of damage to IT systems in the event of a natural or human-induced disaster), and security. Table 1. Scope of domestic IT services Type Details -Long-term IT planning; implementation and management of enterprise solutions; IT consulting networking/device solutions; equipment management consulting -Management and consulting services for security, etc. -Project planning; scheduling; technology planning SI -Task analysis; program design; application development; coding System -Database development; hardware selection; network design; operating system integration standardization - Heterogeneous integration (packages, hardware, networks) - Post-development testing, maintenance, etc. IT SM infrastructure Data center/hardware/network management (outsourcing) management SM System management/maintenance on an outsourced basis Source: ITSA, Mirae Asset Daewoo Research Figure 7. Domestic IT services (SI + SM) (Wtr) 12 SM SI 10 5.1 5.2 4.9 5.1 8 4.6 4.8 6 4 6.4 5.6 5.8 5.9 6.1 6.2 2 0 13 14 15 16 17 18 Source: KRG, Mirae Asset Daewoo Research Mirae Asset Daewoo Research 4 April 11, 2019 IT Services 2. 2019 market outlook For 2019, KRG forecast that the Korean IT services market would expand 3.5% YoY to US$11.8bn, and that the global market would grow 4.8% YoY to US$1.034tr. The domestic IT services market has displayed relatively slow growth of 3-4% since 2015 and accounts for a mere 1.2% of the global market, as Korean companies tend to spend less on IT than global peers. Indeed, total IT spending as a percentage of revenue is very low for Korean firms. However, given the growing focus on IT’s importance in driving competitiveness, we look for a steady increase in IT spending going forward; as such, we believe that expansion of the domestic IT services market is likely to accelerate. Notably, in addition to traditional IT services, we expect explosive growth in demand for high-tech services (e.g., IoT, cloud computing, Big Data, mobility) related to the Fourth Industrial Revolution and digitalization, which will create new opportunities for IT service providers. We expect IT demand to grow not just in the private sector but also in the public sector. We project demand for IT services to be driven by policy supports for the IT service industry, as the government has been establishing institutional frameworks for new businesses and opening up public project bidding to large conglomerate-affiliated IT services companies equipped with new technologies. Figure 8. Domestic IT services market trend and outlook Figure 9. Global IT services market trend and outlook (US$bn) (%) (US$bn) (%) 16 Market size (L) 8 1,600 Market size (L) 8 Growth (R) CAGR (19-22) Growth (R) CAGR (19-22) +4.8% +12.5% 12 6 1,200 6 8 4 800 4 4 2 400 2 0 0 0 0 15 16 17 18 19F 20F 21F 22F 15 16 17 18 19F 20F 21F 22F Source: KRG, Mirae Asset Daewoo Research Source: KRG, Mirae Asset Daewoo Research Figure 10. IT services market size by country and % of global Figure 11. Total IT spending as % of revenue: Korean vs. market global companies 3.3% (US$bn) (%) 56.5 600 Market size (L) 60 Contribution to global market (R) 500 50 400 40 300 30 200 20 0.6% 6.6 8.0 100 4.2 10 1.2 0 0 Korea China Germany Japan US Domestic Global Note: Based on 2018 data Source: KRG, Deloitte, Mirae Asset Daewoo Research Source: Gartner.