IT’s up against odds

K Venkatasubramanian | Updated on January 24, 2018




The going’s getting tougher for the tech industry with cross-currency woes, pricing pressure in traditional products and inability to make headway in new digital technologies

There was a time when the IT sector was considered the perfect defensive, as revenue growth was robust across economic cycles and the sector enjoyed valuations on par with FMCG and pharma companies. This has changed now. In the last 12-18 months, and especially over the last couple of quarters, the software segment seems to have lost the ‘defensive’ tag.

The March quarter saw weak revenue growth across almost all companies in the sector, unlike previous periods when there would be a divergence in performance, with some delivering and others lagging behind.

For the first time since 2008-10, questions are being asked about earnings visibility and analysts have been quick to downgrade price targets for many large and mid-cap IT stocks.

The trailing 12 months valuation multiples, at 15-25 times, are lower than the 20-28 times that these stocks traded at over the previous three-four years. From their recent peaks, stock prices have corrected 10-25 per cent in the last couple of months.

So, what should you do now with the IT stocks in your portfolio? Many of the stocks in the sector are currently facing headwinds that can dampen their performance in the near future. Going selective on just a couple of names appears advisable.

It was expected that FY15 would be better than FY14 (when the rupee fell sharply against the dollar, aiding revenue growth in local currency). Even after factoring in rupee weakness in the previous fiscal, revenue growth in 2014-15 was a good 3-4 percentage points lower for most software companies.

Many challenges confront the sector, including cross-currency woes, pricing pressure in legacy services offerings, poor traction in verticals such as telecom and energy and as yet insignificant revenues from newer digital technologies. Also, unlike global IT majors, Indian IT players generally do not carry out large acquisitions and would certainly not do so for scale.

But on the margin front, these companies are still well placed. Fixed price projects are on the rise, automation of many functions is gaining traction, utilisation rates are at healthy levels and client additions are fairly robust.

Here we analyse the factors that would indicate that the going may be tough for many players in the sector for the foreseeable future, though select companies may still come out trumps.

Euro weakness hurts

In 2014-15, the dollar was very strong and given the expectation of a rate cut by the Federal Reserve, the euro, Australian dollar and, to some extent, even the British pound depreciated significantly.

Companies such as HCL Technologies, Infosys, Wipro and TCS, as well as several mid-tier players, receive 23-35 per cent of their revenues from Europe. So, when the euro depreciated by nearly 20 per cent against the dollar in FY15, these companies faced a severe dent in their revenues and realisations.

In the March 2015 quarter alone, revenues were hurt by 200-250 basis points for top-tier as well as mid-sized IT companies.

The other important headwind has been pricing pressure from many clients across the board. After 2008-09 and for a brief while in 2011, there has been a fall in realisations for most IT companies in 2014-15.

Part of this slippage in realisations also has to do with a weak euro. Infosys, for example, has had a 300-basis-point fall in realisations in FY15 and it was especially severe in the March quarter. The case was similar with varying degrees at HCL, TCS and Wipro. It is quite likely too that the pricing pressure is not going to go away any time soon.

Some companies, such as Wipro, have indicated that they are talking to clients to pass a portion of the benefit of a weak euro back to them.

However, it remains to be seen if this comes through.

Multiple segments not firing

For many years now, telecom as a vertical has remained quite weak. In fact, over the years, from mid-teen levels, the vertical has gone down to single-digit contribution to revenues for many players. Given the huge capex investment required for the sector in view of the global thrust on data usage, global telecom majors are facing margin and pricing pressures.

With new apps eating into voice and data revenues of operators, there is added pressure on the segment.

Energy and utilities, especially from Europe, had delivered extremely well for Infosys, Wipro and HCL Technologies during 2011-13. But thanks to the steep fall in crude oil prices, several players have cut down dramatically on capex and also IT spends over the last three-four quarters.

The other major concern has been that the North American geography (largely the US) has not been firing.

In earlier years, the growth in Europe used to somewhat make up for the slower show in the US.

But quarterly revenues (on a year-on-year basis) from the US have reduced from 12-20 per cent levels to 6-15 per cent in recent quarters. Clearly, the largest outsourcing nation is not handing out deals, at least the normal bread-and-butter contracts, in a hurry.

Indeed, most of the frontline IT companies have indicated that decision making on IT outsourcing is now going all the way to the board of the clients before getting finalised, making the deal finalisation process longer.

Fighting the digital battle

All the traditional offerings such as application development and maintenance, infrastructure services and business process outsourcing (BPO) have now become commoditised.

Indian IT companies derive anywhere from 60 to 90 per cent of their revenues from such offerings. A large part of these services is facing severe pricing pressure.

As clients move towards complete digital transformation of their systems and processes, the challenges for Indian players are going to get tougher. So, social, mobile, analytics and cloud (SMAC) or delivering software as a service (SaaS) or other digital transformation contracts are the way many clients are moving forward.

While traditional services and delivery modes will exist, their growth is expected to come down dramatically.

For most Indian players, these ‘digital transformation’ deals are yet to become a line item in reporting as they still receive a very small portion of their revenues from them. In contrast, global consulting and IT major Accenture reportedly derives 20 per cent of its revenues from such deals. This is sure to eat into Indian IT vendors’ pie.

Inadequate acquisitions

Capgemini, the Paris-based IT major that competes with several Indian vendors, is in the process of acquiring mid-tier IT player IGATE, for $4 billion. Capgemini had revenues of $11.2 billion, while IGATE reported sales of $1.3 billion in CY 2014.

Now, Capgemini, which had limited reach in the US, would be able to tap into IGATE’s strong footprint in the North American geography. This means added competition to Indian IT players.

Last year, Cognizant acquired TriZetto Corporation for $2.7 billion which is likely to improve the former’s presence in the healthcare vertical.

Indian IT players have generally shied away from making such large acquisitions, preferring instead to do smaller mergers in areas where they do not have presence. In order to gain scale, they have rarely gone on to take over large players, generally due to concerns over integration.

TCS’ acquisition of Citigroup Global Services and HCL’s Axon buy are the only large acquisitions in the last six-seven years. These were more to gain capabilities than scale.

With piles of cash in the $1.5-5 billion range among top-tier IT players and with margins between 21 and 27 per cent, these companies may be excessively cautious. Global players, in comparison, are happy with 11-19 per cent operating margins.

The likes of Accenture, IBM and even a pure-play IT vendor such as Cognizant may pose increasing competition for Indian software majors.

Margins still work out

While the challenges in gaining revenue growth and market share do exist, on the margin front, many Indian companies are changing their working model.

Indian vendors, both large and mid-tier, are increasingly focusing on deriving a greater share of their revenues from fixed-price contracts, which ensures better realisations compared with ‘time and material’ projects.

So, in FY15, 42-56 per cent of revenues came from fixed-price projects for IT players. This is an improvement of 4-10 percentage points over the previous couple of fiscals for both large and mid-tier players.

The shift in the mode of project billing is also preferred by clients as it gives certainty on deadlines as well as resources deployed. Many players are also increasing another key margin lever — utilisation rates. For large IT players, the utilisation ratio is at 80-85 per cent, while for mid-sized companies the levels are at 70-75 per cent. There has been a 300-500 basis points improvement across the board in FY15.

Clearly, IT companies are maintaining lower bench strength and billing a large share of their resources. This has optimised costs significantly.

Then there are innovations taking place on the service delivery front.

For example, the likes of Infosys and Wipro have increasingly laid emphasis on automating basic commoditised service offering to a significant extent.

With focus on artificial intelligence and automation, the workforce deployed is expected to reduce significantly over the next few years.

The emphasis is on building platforms and offering integrated services.

There are reports suggesting that in the case of Wipro, there is expected to be a 30 per cent reduction in workforce in three years due to the focus on automation.

This does not mean firing of people, but more a case of employees leaving as a part of regular attrition not being replaced with more personnel.

Stocks to bet

On the whole, revenue growth challenges do appear quite significant for several players.

The one key positive is that all the major players have still had healthy large-sized client additions. So in the $20-100 million categories, these companies have increased the count of customers.

For FY14, the IT industry exports grew at 13-14 per cent. In FY15, the number is expected to be 12-14 per cent, according to industry body Nasscom. So, there has been a mild fall.

Given that several players have had concerns in the March quarter, there is uncertainty on whether the expectation built last fiscal will be met.

Analysts are also factoring in more downside risks to revenue growth in FY16. With competition from global players such as Accenture, Capgemini, IBM and Cognizant only set to increase, Indian IT players would be hard pressed to expand their pie.

For around three years now, Infosys and Wipro have grown at single digits and at nearly half the industry growth rate. With very little consistency in quarterly numbers for over three years now, a strong turnaround does not seem to be on the anvil immediately for these two IT majors.

TCS and HCL Technologies too have had weak periods in recent times, and valuations are not cheap. So, these two stocks may be retained if investors already have exposure, and not add any more even on corrections, as is the case with Tech Mahindra.

From the mid-tier pack, although not inexpensive, Mindtree and Persistent Systems have grown much faster than the industry rate consistently over the past few years and have not had too many concerns other than on currency. Investors could buy these stocks and look to accumulate Hexaware Technologies, given its strong turnaround.

The one company that has both growth and reasonable valuations to go with it is Zensar Technologies. Though the stock has run up after its March quarter results, it is still cheap at 12 times trailing earnings and could be a safe bet for a two-three-year horizon.

Staying away from niche plays in the manufacturing or financial services segments would be a safe option for investors.

Published on May 31, 2015

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