How AI Will Likely Disrupt IT Services Moats

How much of a threat does artificial intelligence pose to the economic moats of IT services stocks?

We believe the best way to analyze the potential disruption is to approach the industry by service category. There are three types of services along this value chain, with consulting at the top, system integration and application development in the middle, and business process outsourcing at the bottom.

Moats Should Remain Intact for Consulting Services

The main moat source for consulting is intangible assets, supported by C-suite connections, brand, and institutionalized knowledge. We see minimal disruption from AI in this area. The technology cannot replace the connections between IT service companies’ partners and customers’ C-suite decision makers.

AI Brings Both Growth and Challenges to System Integration and Software IT Services

For system integration and application development, moats come from a combination of intangible assets and switching costs. We think AI brings both new growth points and challenges.

If enterprises want to roll out AI throughout the organization, they need help from IT services companies to set up the infrastructure. We already see this trend in financial services, as banks and insurance companies turn to IT consultants to deploy AI use cases like automated claims processing.

In addition, AI-related work is considered a premium system integration offering compared with traditional workloads. As IT spending shifts toward AI-related tasks over time, this can help lift the margins of IT services companies.

On the other hand, AI-led efficiency gains in software development mean fewer billable hours under a time and materials pricing model. IT services providers inevitably need to pass all the cost savings to clients, which can hurt their margins. To mitigate this headwind, we expect to see a faster transition to fixed-price and outcome-based contracts.

Business Process Outsourcing Will Face the Biggest AI Disruption

Few companies have historically developed moats for business process outsourcing, given the demanding unit economics. The moats that do exist come primarily from the cost advantage of using offshore labor.

We believe this segment will see the biggest AI disruption if the technology can provide better services at a lower cost than human agents. At the moment, the total cost of ownership for AI-native systems is too expensive for widespread adoption. However, we would not be surprised to see an inflection point in the next few years wherein enterprises begin to adopt those systems on a massive scale as generative AI becomes cheap enough.

We do not necessarily view this possibility as negative for the full-service IT consultancies under Morningstar’s coverage. Implementing AI systems to replace offshore labor essentially shifts BPO work to system integration and application development, which should lead to margin improvement.