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Information Technology
IT Sector: Time To Put Cash To Good Use:
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In our view, the current weak global macroeconomic scenario provides an excellent opportunity for Indian IT companies to augment their business model by shifting to the “value creation“ model, which involves deploying huge cash balances for making suitable acquisitions. Besides, we continue to remain positive on the long-term growth outlook, considering the off-shoring abilities, the global delivery capabilities, and the strong functional expertise of the Indian IT players. However, we believe that the sector
will witness a slowdown in volume growth and pressure on margins in the medium term despite assistance from the depreciating rupee vis-à-vis the dollar.
1.Business Model Shift:
From ‘cost arbitrage’ to ‘value creation’ We believe that the current scenario provides an excellent opportunity for the Indian IT companies to move away from the “cost arbitrage” model to the “value creation” model. Large players such as Infosys, Wipro, and TCS have huge cash balances, ranging from USD 400 mn to USD 1.75 bn. We believe that these companies can utilise this cash to push their inorganic growth plans as many small/mid-size IT companies across the world are available at attractive valuations.In this way, the Indian IT companies can improve their product offerings, increase their spread into newer services/technology verticals, as well as diversify geographically. Such a strategy should equip the Indian IT companies to target end-to-end transformational deals and command better pricing power in the future.
2.Long-term growth intact:
In our view, the Indian IT players’ delivery capability and the focus on high-end services will ensure their long term growth. We believe that off-shoring will continue to increase as it provides a win-win situation for both the clients and the IT players.
This is because off-shoring costs less than on-site services and enjoys higher profitability. Currently, IT players are setting up off-shore development centres (ODCs) at locations other than India to service non-English speaking clients in Japan, China, and Eastern Europe. Besides, with a foray into high-end consulting services, IT companies will be able to command a larger share of their clients’ IT budgets.
3.Global turmoil:
Volume growth to slow, margins to dip by 2–4% in the next 2 years Given the current weak global economic scenario, we expect the volume growth for the Indian IT companies to slow down to around 5–15% p.a. in the next 2 years,compared with around 20–35% p.a. for the last two years. Additionally, we expect the operating margins to decline by 2–4% in the next 2 years. As many clients are
delaying their planned projects and are slowing down the ramp-ups of new projects,we expect the overall volume growth to decelerate. On the other hand, large BFSI clients may force the IT companies to cut prices in the near-to-medium term.
Moreover, reduced activity could force existing players to resort to price undercutting in order to win large deals. Furthermore, the IT companies’ efforts to improve geographical and vertical diversification will push their SG&A spending higher. As a result, the operating margins are expected to come under severe pressure in the near term.
4.Rupee deprecation:
A short-term relief The rupee has deprecated by more than 20% in the last few months, easing the pressure on the margins and providing much-needed relief to the sector in the near term. However, we expect this advantage to disappear in the medium term. In our view, the rupee will climb up to nearly Rs. 44 in FY10 on the back of a relatively better performance of the Indian economy (vis-à-vis the US economy) and the resumption of the Foreign Institutional Investors (FII) inflow into the Indian markets post the stabilisation of the global financial markets and the return of investor confidence.