The IT industry is changing at breakneck speed. The success of the offshore delivery model that led the golden era of the industry is breaking up with automation and digital technologies gaining ground. Indian IT service vendors that rode on the success of large traditional outsourcing deals, have been late entrants in the digital space. The industry is structurally moving away from commoditised businesses to high-value technology-driven deals, but it may be a while before Indian players establish a meaningful presence in the SMAC — social, mobile, analytics and cloud — offerings space.

A ‘price-war’ like situation in legacy services, increased headwinds from unfavourable currency movements, slowing growth in IT spends — all these are clear challenges over the next two to three years. Some companies, such as Infosys, HCL Tech and Tech Mahindra, appear better placed than others. Investors need to watch out for some of these challenges facing the sector.

Shrinking budgets

The IT outsourcing market globally is in a tight spot. After growing at 6-8 per cent annually during 2003-2008, IT Services spending grew just 1.5-1.8 per cent a year, between 2012 and 2014. The year 2015 was no different. A strong dollar and anaemic pace of growth in consumer spending saw many American companies rein in their IT budgets. The Indian IT services industry earns a large chunk of its revenue from exports to the US. Of its total revenue of $98 billion in 2014-15, 62 per cent was from the US. Nasscom, in a recent release, estimated the country’s IT/ITeS industry growth for 2015-16 at 12.3 per cent, which is at the lower end of its earlier estimate of 12-14 per cent.

Indian IT companies that have large digital presence and serve clients in SMAC have, however, emerged as winners. Infosys is a case in point. Revenue growth from North America accelerated to 10.11 per cent in the December 2015 quarter, from 8.44 per cent in the December 2014 quarter. But for TCS, the growth from the region slowed to 8.69 per cent in the latest December quarter, from 12.6 per cent last year.

The impact of lower IT spends in the US reflects on the revenues of Indian IT services companies with a lag of a quarter, say experts. The US Manufacturing PMI recorded a reading of 51.8 in March — the first reading above 50 since August last year. But, given that the manufacturing sector was contracting until recently, growth challenges may persist for Indian IT companies. However, companies that are able to garner a large share of the digital spends of their US clients may do well since that is the space that is expanding fast.

For the current year, Gartner estimates that the North American market will see a 4.3 per cent increase in total IT spends. While spending on traditional BPO services is expected to increase 4 per cent, spending on cloud services is likely to grow 44 per cent. This clearly shows where the opportunity lies.

The European market is not very promising at the moment. The top five Indian IT companies derive 15-20 per cent of revenue from the UK and continental Europe. With the recent stimulus, economic activity in Europe may pick up but, again, that may not happen immediately. The worldwide IT spends are expected to increase 0.6 per cent in 2016, but the 2014 spending of $3,737 billion won’t be surpassed until 2019, says Gartner.

Digital — long way to go

While Indian IT exports have grown manifold in the last decade (from $13 billion in 2003-14 to $98 billion in 2014-15), growth from here will depend on how quickly IT players adapt to the changing times. Developing skills in digital technologies is the only way to survive competition and grow revenues. Globally, companies are looking for IT partners who can help not just in software maintenance but also offer end-to-end customised solutions through technologies such as cloud and analytics.

In the last two-three years, Indian IT companies have started to invest in digital capabilities through the inorganic route. TCS’ acquisition of Computational Research Laboratories in 2012 (offers cloud and other application services), Tech Mahindra’s acquisition of Comviva (mobility) in 2013, Wipro’s acquisition of Opera Solutions (big data analytics) also in 2013 and Infosys’ Panaya (SaaS testing platform) acquisition in 2015 are some instances.

Some companies have also been investing in developing in-house capabilities in automation. However, given the stiff competition from players including Accenture and Cognizant, it may be difficult for Indian IT service vendors to win meaningful share in the digital market in the next one-two years. The US-based Cognizant Technologies, for instance, has raced much ahead of the domestic IT companies over the last few quarters. In the recent December quarter, while constant currency revenue growth (year-on-year) was 12.5 per cent for Infosys and 9.9 per cent for TCS, Cognizant saw a 17.9 per cent growth. The company’s fast paced growth is thanks to its early entry in digital technologies.

Indian companies have been conservative, placing more emphasis on deal valuations when it comes to mergers and acquisitions. This is one reason why India-based IT companies have lagged global peers in grabbing opportunities in the digital space, say experts. TCS has faced criticism for its slow-paced achievements on the digital side despite being one of the early starters, because of its conservative approach. However, the company maintains that it can do well on the digital front without going the inorganic route. In a recent analyst meet, TCS disclosed that it has trained over one-third of its workforce in digital skills in the last one year and makes about 13-14 per cent of revenue from digital solutions.

The size of digital revenue of Indian IT companies is not clear as not many report it. Also, given the varying definition of digital among companies, comparisons are not easy. So, how do we identify companies that are doing well on the digital front and those that are not? In the last four quarters, it was clearly companies with larger digital engagement that did well. Cognizant Technologies reported 18-20 per cent year-on-year dollar revenue growth in each quarter of 2015. Of the India-based companies, Infosys did better than its other large-cap peers. MindTree has also shown progress in digital revenues. Revenue from digital services as a proportion of overall revenue of the company stood at 36.1 per cent in the December 2015 quarter, up from 33.1 per cent last year. The company’s overall revenue grew 24.8 per cent, year-on-year, in the recent December quarter, up from 16.2 per cent in the same period in 2014.

Demand slowdown

Indian IT Service companies make 30-40 per cent of their revenue by servicing banks, financial service companies and insurers (BFSI) and most of these are based out of North America. But given the stressed condition of banks and financial institutions due to exposure to oil companies, Indian IT companies too are facing pressure. TCS’ BFSI segment (contributes 40 per cent of revenue) saw sequential revenue growth of only 0.7 per cent (in constant currency) in the December 2015 quarter, down from 3.3 and 3.9 per cent in each of the preceding two quarters. Infosys’ BFSI division (contributes to a third of revenue) saw a sequential growth of 3.1 per cent in the recent December quarter, down from 6.4 per cent in the September quarter.

Companies that have lower exposure to the financial sector have not done too well either, due to their presence in other troubled sectors such as oil and telecom. Wipro, for instance, makes only about 25-26 per cent of its revenue from the BFSI segment, but its exposure to telecom and oil together is about 27 per cent (for TCS and Infosys it is only 5-10 per cent). The company’s energy biz recorded flat revenues in the recent December quarter while the telecom (and media) segment recorded a small 2.7 per cent sequential growth. The telecom industry globally has been under pressure due to increased competition and consolidation activities. The segments that have been faring well for a year now are healthcare and retail where experts say discretionary spends have been growing without much slowdown. Cognizant’s outperformance vis-à-vis other players in the domestic market is also because of its higher exposure to the healthcare segment. Indian players, however, have only 10-12 per cent exposure to these segments.

Rupee: the wild card

The common notion that a falling rupee can boost margins of IT companies has been turned on its head. Rupee-dollar movement alone does not impact the margins of IT companies anymore. Take Infosys, for instance. The company’s operating margins have dropped from an enviable 29-30 per cent in 2009-10 to 25 per cent now. This is despite the sharp fall in the rupee from 44-45 against the dollar to 66 during the same period. The key reason is that, unlike in the past, clients now want IT companies to pass on some of the benefits from a favourable currency movement to them in the form of lower pricing. Further, IT companies earn a fair bit of revenues in currencies other than the US dollar. TCS currently earns over 40 per cent of revenue from currencies other than the US dollar. Infosys makes about 70 per cent of revenue in US dollar, down from 79-80 per cent almost a decade back. The company has also seen a marked rise in euro revenues (10 per cent vs 5 per cent earlier). Higher dollar expenditure of companies also mitigates the impact of a favourable rupee dollar movement. Earlier, much of the bread and butter application development and maintenance (ADM) work was done offshore.

But now, with clients wanting end-to-end support, there is need for employees to be present in onsite locations, increasing dollar expenses.

In the recent December quarter, Infosys reported operating margin of 24.9 per cent, down 0.6 percentage points over the September quarter and down 1.8 percentage points over last year. Similarly, TCS, Wipro and HCL Technologies, too, saw margin erosion of 40-180 basis points. Between the December 2014 and December 2015 quarters, while rupee weakened against the dollar, it appreciated against the euro and Australian dollar.

Companies have been trying to pull all levers to improve margins. Efforts are on to improve employee utilisation, develop better onsite/off-shore mix and increase the use of automation in new and existing projects. But, given that competitive pressure, especially in traditional services is only going to intensify, Indian IT companies need to step up their digital and automation initiatives. Large companies reporting a drop in realisations in recent quarters highlight the need to adopt newer models to lower costs, and fast. Clearly, Indian IT companies would need to either shape up speedily or ship out.