Scaling up and the need to build digital capabilities will lead to faster consolidation among the mid-tier information technology companies in India, domestic ratings agency Crisil said on Tuesday.
The IT companies' legacy businesses such as time and material contracts have become commoditised, posing significant growth and profitability challenges, it said, spelling out the reasons which will drive this consolidation.
Exit by promoters of tier II firms in the past two years who are capitalising on higher valuations and better growth prospects will also drive this trend, it said.
The agency said it has analysed 22 such mid-tier IT firms with turnover between Rs 1,000 - Rs 10,000 crore and found that there is a consolidation opportunity in Rs 33,000 crore worth of market capitalisation.
Without taking any names like Bengaluru's Mindtree which is being acquired by L&T, it said moves entailing switch of ownership for Rs 18,000 crore are already in progress.
"Such consolidation engenders manifold synergies, boosts profitability and builds capabilities to cope up with opportunities in the digital space," it said.
It said scale is very important in the IT business as clients prefer to work with established players with proven execution records, and pointed out to slower revenue growth of 13 per cent posted by mid-tier players between FY13-19, which is 3 percentage points slower than the tier-I firms.
The tier-II companies have been slower in embracing the digital services arena, which has grown at 30 per cent over the past three years, it said.
As a result, digital revenues for tier-II firms have grown at a slower pace (15 to 22 per cent in three years), than the same for tier-I firms (17 to 29 per cent).
Tier II firms need to build competences to stay in the game, it said, adding competition is also hotting up for digital contracts in the banking and finance vertical which is the mainstay of tier-II firms.
"This will push tier II firms further towards consolidation...also, tier II firms operate largely with a few large customers. Consolidation will, therefore, afford business complementarity and cost rationalisation, which will narrow their operating margin gap with tier I firms," the agency's director Sameer Charania said.
The agency said operating margins of tier II firms were also significantly lower at 16 per cent over the fiscals 2013-19 as against 24 per cent for tier I firms which is reflective of the formers lower pricing power and higher cost base.