Introduction:

Our Software and IT Services Demand Barometer is a composite index of several variables that we believe are leading indicators of demand for the European sector. It was first formulated by Benjamin Berenson back in 2001 and members of this team have developed it further to the index you see today. We have used it extensively in supporting our overall sector views over the years and it has served us well.

Our index is a “diffusion” index, calculated in a similar fashion to the US ISM indices.  The final result reflects the number of variables that have increased, decreased, or remained unchanged on a month-to-month basis. Hence, a reading above 50 indicates expansion from the previous month, while a reading below 50 indicates decline from the previous month.

The IT Demand Barometer dropped back to a modest decline in IT demand in August, following a brief expansion in July.

Figure 1: The IT Demand Barometer from January 1998 to August 2009

Recent trends:

After falling to an all-time low of 27.3 in January 2009 (significantly worse than the prior trough of 32.3 in November 2001), the reading has revived: The IT Demand Barometer increased from 27.3 in January to 52.7 in July 2009, before dropping back to 44.8 in August.

Though this may be interpreted as a revival in demand for Software and IT services may be near, our experience after the bursting of the tech bubble showed there were a number of false dawns as fiscal policy stimulus delivered temporary respite (November 2001 to April 2002 and September 2002 to January 2003) before the sustained growth period from July 2003 to December 2007.

The recent rise in the IT Demand Barometer is mainly attributable to an improvement in IT staffing data in the UK and an improvement in the general economic conditions. However, US permanent IT staffing data has still not shown signs of improvement.

Constituent component movements:

Micro Indicators:

IT Staffing levels:

The US technology industry cycle is generally a few months ahead of Europe and any major trends in demand in the US technology sector are likely to be witnessed in Europe in the next few months, so it is important to look at data from the US technology sector for lead indications. For this reason, we look at IT staffing data in the US and UK (UK being the one of the largest IT services market in Europe and because relevant data for the UK is available in greatest detail).

The US IT staff and temporary help services data are taken from the US Bureau of Labour Statistics data (computer systems design and related) and modified to indices that reflect expansion (increase in employment) or contraction (decrease in employment). UK IT Staff data is available in the form of a diffusion index (an index that indicates expansion or contraction depending on whether it is above or below a steady-state level) published by Markit.

Figure 2 shows that while the Permanent and temporary IT staff indices appear to move together, the temporary index seems to slightly lead the permanent index. This can be explained by the fact that companies would prefer to lay off temporary staff ahead of its permanent staff. There also appears to be some correlation between US and UK IT staffing levels. But in the US, it is clear that the temporary staffing is much more volatile and any changes in staffing are likely to have the first impact here.

From this we can conclude that the temporary IT staffing data is a key lead indicator of IT demand, and these indicators forms a key component of the IT Demand Barometer.

Figure 2: Micro Indicators: Permanent IT Staff and Temporary Staff Diffusion indices for the US and UK (3 month moving averages)

After the steep falls during the 2008 recession, US temp help services staff growth seems to have reached a trough in Jan 2009 with permanent and temporary UK IT staff showing similar troughing in March. Recent trends show an improvement in staffing data, particularly in the UK, though not yet back to expansionary levels. US temporary staffing data, however, has still not shown signs of improvement while US permanent staffing data has been flat for the last few months.

Macro Indicators:

EU Corporate Profits growth forecast:

Generally, it is reasonable to expect that a firm’s IT investment plans will depend to an extent on its profits and profit outlook. A loss making firm is highly likely to cut back on its IT budget, while a profitable firm would look more favourably on investment in IT to support growth. We look at 12 month forward earnings forecast on an industry wide basis to get an indication of corporate profitability expectations. Our experience suggests that bottom -up aggregate forecasts, such as these, tend to have less lead over the real economy performance, but remain the best available measure of explicit profit expectations.

As we can see in Figure 3, during periods of recession, corporate profit forecasts have shown a drop – no surprises here. But we are particularly interested in this as an expectations measure and are focused on the changes in expectation.

Corporate Profit forecasts have bounced back after being negative from April to July 2009.

Figure 3: Macro Indicators: 12m forward EPS growth forecast for FTSE Europe (Source: Datastream)

EU Economic Sentiment indicator:

The economic sentiment indicator published by the EU commission, is a composite indicator that accounts for industrial confidence, services confidence, consumer confidence, construction confidence and retail confidence, thereby giving an overall indication of the sentiment in the economy. The EU economic sentiment indicator could give a useful indication of broad investment trends of which Software and IT Services will be part.

As seen from Figure 4, the most recent data shows a likely bottoming following an extremely steep fall.

Figure 4: EU Economic Sentiment Indicator (Source: EU Commission)

Appendix:

Key inputs include:

Changes in temporary IT staffing on a monthly basis. We believe this is an excellent proxy for the marginal demand for IT services projects – e.g. if the use of IT contractors trends up it suggests a more robust environment.

Changes in permanent IT staffing. Interviews with IT services providers and in-house IT teams suggests permanent staffing levels have greater latency vs. changes in the demand environment, but carry greater weight in assessing medium term as opposed to short term demand trends.

Changes in overall macro-economic leading indicators that are correlated with IT spending. Most of our analysis suggests that business confidence is the prime determinant of willingness to spend on IT; therefore we incorporate factors such as EU business confidence surveys, expected corporate profitability, and other leading indicators (though they are weighted less than our staffing variables).

Interpreting the results:

Our index is a “diffusion” index, calculated in a similar fashion to the US ISM indices.  The final result reflects the number of variables that have increased, decreased, or remained unchanged on a month-to-month basis. Hence, a reading above 50 indicates expansion from the previous month, while a reading below 50 indicates decline from the previous month.

Predictive power:

We have designed the IT Demand Barometer to inject some quantitative rigour into assessing the very subjective issue of European Software and IT services demand. While it is not a substitute for channel checks with CIOs/IT purchasers or other anecdotal sources, we believe it provides a useful complement.

Assessing the predictive power of the index is difficult without an objective measure of IT services demand for historical “back-testing”. Measured against major policy and market turning points it shows good results.

While the Barometer is not designed to predict the performance of stock prices in the Software and IT services sectors, it does show good results over time especially at turning points, but sector volatility can be distracting.

Constituents:

Micro indicators:

US IT Staff Change Index (source: US BLS Data)

US Temporary help services Change Index (source: US BLS Data)

UK Permanent IT Staff Diffusion Index (source: Markit survey)

UK Temporary IT Staff Diffusion Index (source: Markit survey)

Macro indicators:

EU Corporate Profits growth forecast (source: Datastream, FTSE Europe 12m EPS growth forecast)

EU Economic sentiment indicator (source: EU Commission)