Forbes India 15th Anniversary Special

Indian IT faces 'dilemma of disruptive situations'

The double whammy of margin pressure and the need to spend on training will force India's top outsourcing providers to step up innovation in 2017

Harichandan Arakali
Published: Jan 9, 2017 05:02:16 PM IST
Updated: Jan 9, 2017 07:22:52 PM IST

Indian IT faces 'dilemma of disruptive situations'
Image: Shutterstock

India’s biggest IT companies kick off their quarterly earnings season with the top-ranked Tata Consultancy Services (TCS) set to report its numbers on January 12, followed by Infosys the next day. There will be little evidence of any big shifts in growth.

In the coming year, however, clues will emerge on how much progress they have made on the journey towards becoming ‘problem finders’, as Infosys CEO Vishal Sikka says, which holds the key to higher-margin growth. Their current avatar of being excellent ‘order takers’ still defines much of Indian IT, but it is a role doomed to never-ending billing rate declines.

Therefore, the more the Indian IT companies equip themselves help their biggest customers make money, and not just save costs, the better they will be positioned to thrive. Acquisitions will play a role, such as Wipro’s purchase of Appirio, a cloud services specialist, as will technological capabilities from startups, such as TidalScale and IdeaForge that Infosys has invested in.

For now, for growth to return, “the catalysts are still likely a few quarters away,” Kuldeep Koul and Bhrugesh Parsawala, research analysts at Mumbai brokerage ICICI Securities, wrote in a note on December 29. “On core fundamentals, we believe demand should pick up in FY18 when, one, front-ended aspects of digital-like advisory and user experience give way to downstream digital integration projects at scale, and, two, we see some abatement of pricing pressures on the legacy business,” they added.

The latter is a tough task, because the legacy business, or the existing IT outsourcing model, is out of favour with the largest buyers. “We see a declining price and a downward pricing pressure in the industry. The customers themselves are under tremendous price pressure because of the digital disruption that they face,” Sikka said at a Credit Suisse conference on November 30. “And the global delivery model, the basic global delivery model, is not something that is so differentiated anymore.”

India’s IT sector also faces a slew of external factors going into the new calendar year. This includes the decision to leave the EU by Britain, the outsourcing sector’s second-biggest market and the election of billionaire Donald Trump as the next president of America, the world’s largest economy, on a plank that included tough restrictions on the use of visas such as the H-1B, the mainstay of Indian IT industry.

“Though large cap stocks are trading well below their historical valuations and look optically inexpensive in the backdrop of status quo on demand, any changes in the visa regulation can pose significant risk to revenue and margin estimates, making it difficult to take a unilaterally bullish view on the sector,” the ICICI Securities analysts added.

For the fiscal third quarter, the three months ended December 31, Koul and Parsawala expect revenues at the top five companies combined to rise by 0.5 percent from the previous quarter and 6.9 percent from the year-ago period. Individual companies will see the effect of factors specific to them, including a $27 million in revenues from India that TCS might recognise for the December quarter, which it had earlier anticipated from the fiscal second quarter, or the full-quarter effect of revenues from Appirio for Wipro and the effects of the ramp-down in a large contract Infosys had anticipated from Royal Bank of Scotland.

For the full year ending March 31, 2018, the analysts project revenue growth for the Top-five companies to be “modestly higher” at 8 percent versus an expected 7.2 percent in the 12 months to March 31, 2017, and 7.1 percent reported in FY16. Excluding the effect of currency fluctuations, they expect the EBITDA margin for top five companies to decline to 23.9 percent in FY18 from an expected 24.1 percent in FY17. EBITDA margin for the top five has already declined from 27 percent in FY14 to 24.7 percent in FY16, they pointed out.

As to external factors, as a thumb rule, an increase in interest rates by a nation’s central bank points to an anticipated pick up in the growth of the economy. Therefore the recent rate increase in the US is broadly good news for Indian IT. And the US Federal Reserve expects to raise rates three more times in 2017.

“As the dust settles post the US elections, economics could replace rhetoric,” Sandeep Gogia, associate director at Equirus Capital in Mumbai, said in an emailed statement on January 5. On the one hand, the Indian IT companies may have to contend with increased visa costs and greater spending on more local hiring. On the other, they will benefit from some of the measures promised by US President-elect Trump, he says.

Trump’s plan for public spending on infrastructure and financial deregulation will likely “rejuvenate” the US banking and finance sector, Gogia says. Banking, finance and insurance companies are the Indian IT sector’s biggest customers, accounting for about a third of the sector’s revenues, a proportion that is even higher in specific cases such as TCS. Dismantling the Dodd-Frank Act, which was put in place after the 2008 financial crisis, will reduce the compliance burden on banks, Gogia says, freeing up money on spending including technology.

The net result will still be a mixed bag in 2017, as technology is changing at a pace that the IT sector will have to work harder and spend more to keep up with. Automation is a given in every new contract they win, meaning customers expect that fewer IT staff will work to fulfil an order versus earlier. That means the IT companies are fighting for their share of a smaller pie, while being forced to spend on training their employees on automation and digitisation, says Mayuri Yadav, an associate director for research at Equentis Wealth Advisory Services in Mumbai.

At Infosys, Sikka added at the Credit Suisse conference that the entire IT industry faces a “dilemma of disruptive situations” that is exacerbated by the main business itself being under margin pressure. Therefore the industry has to find creative ways to develop talent and build the culture for the next generation businesses while withstanding the pressure to trade increasing proportions of profit for growth, he said.