Mr. Chua, Analyst, focuses on emerging markets. Mr. Crosbie, Equity Associate, focuses on the technology sector. Mr. Leonard, Analyst, focuses on small-cap growth companies.
As businesses work at a faster pace to modernize their technology systems, we believe compelling investment opportunities are emerging. In our view, there are many potential winners competing for a fast-growing piece of technology spending. Digital transformation, or DX, refers to the modernization of legacy IT systems and shifts in business models to digital products and services. For example, making the move to cloud computing is a form of digital transformation.
U.S. businesses will spend an estimated $4 trillion on information technology in 2022, according to Gartner. Of that spending, IT services is expected to be the fastest-growing segment. And a significant portion of that services spend — 40% to 60% — is projected to be for DX. With projected long-term growth rates in the mid-teens or higher, DX is poised to remain the fastest-growing element of most enterprise IT budgets. The pandemic was a positive inflection point, accelerating the need for businesses to pivot to better technology. Many legacy systems were unable to support remote working at scale, and many customer interactions went through rapid digitization.
Collaborating to find potential winners
DX is a global theme that cuts across geographies, industries, and company sizes. With such an immense universe of opportunities, collaboration is critical. The three of us, for example, work as a team and seek to identify alpha-generating ideas before they reach critical inflection points. We specialize in different areas — small caps, emerging markets, and technology — but our overall research is enriched because we share what we learn. Our collaboration has included benchmarking to help target companies likely to exceed earnings expectations. We discuss what we’ve garnered from company management teams and their customers to better understand competitive positioning. We look to make the most of our access to Global 2000 companies and technology and operations leaders — including Putnam’s own — for their perspectives on DX challenges and strategies.
Digital transformation is poised to remain the fastest-growing element of most enterprise IT budgets.
Who are the DX players?
For most businesses, IT departments are focused on the maintenance of existing systems. They are not staffed for the challenge of transitioning to newer systems and services, such as cloud migration, applications development, or mobile technologies. Businesses seeking to transform their systems turn to DX companies, which provide consulting services, product design, and software implementation. DX companies typically operate as an outsourced service. They offer a roster of developers who can implement a modernization strategy for a fraction of what it would cost to hire full-time staff for this purpose. Many DX companies employ “off shore” engineers — so called because they operate in lower-cost geographies. These engineers can execute software implementation more efficiently and at a lower cost than doing it in the United States.
Companies with the potential to benefit from DX trends range from large-cap legacy players to small-cap DX specialists.
An array of possibilities
Companies with the potential to benefit from DX trends range from large-cap legacy players to small-cap DX specialists. Here are four DX companies we believe are worth watching.
Perficient (PRFT). This is a small-cap DX consulting firm primarily focused on U.S.-based Fortune 2000 enterprises. In 2016, the company shifted its strategy to focus more on digital corporate functions and to increase its headcount in Latin America. As a result, growth has accelerated since the onset of the pandemic. While its earnings and free cash flow margins are in line with its best-in-class peers, the stock currently trades at a discount to the group.
Accenture (ACN). Founded in 1989, this company is a large-cap legacy business in the IT services space. Like many legacy businesses, it began by offering both consulting and outsourcing, and therefore has a balanced mix of DX and traditional services. Accenture has consistently stayed ahead of the technology curve. In our view, it stands out among the legacy players because of its digital offerings and a consulting business that is highly valued by C-suite executives and boards around the world.
Tata Consultancy Services (TCS). This leader in the Indian IT service industry has a market cap of over $400 billion. Tata has consistently delivered world-class execution. In recent years, it has been entrusted with digital transformation projects of leading companies around the world, including Swiss Re, NXP Semiconductors, and Walgreens. In addition, Tata has maintained a strong culture that has translated to industry-leading employee retention rates.
Globant (GLOB). Founded and still managed by four friends in Argentina, this company currently has an $11 billion market cap and specializes in DX. Globant managed to double its revenue from 2017 to 2020, and we believe it could double its revenue again by 2023. Disney is a key customer, and Globant is engineering the digital transformation of its amusement parks worldwide.
While DX market growth forecasts are robust, we believe actual growth has the potential to be even higher than anticipated. Enterprises across many industries are emerging from the depths of the pandemic looking to accelerate investment in their digital transformation. And they are leveraging DX companies to help. We believe there is great investment potential in these capital-light businesses that support mission-critical functions.
Putnam equity fund holdings as of 12/31/21: Perficient: Small Cap Growth Fund (1.46%); Accenture: Large Cap Growth Fund (2.16%), Focused Large Cap Growth ETF (2.55%); Tata Consultancy Services: Emerging Markets Equity Fund (3.94%), International Equity Fund (1.80%); Globant: Emerging Markets Equity Fund (1.92%).
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