| IT companies: Tough times ahead |
| Sarath Chelluri / Mumbai March 9, 2009, 0:42 IST |
A weak demand and pricing environment will make it difficult for Indian IT companies to sustain growth and margins.
The worsening economic climate in the US indicates that the challenges will only increase for Indian IT companies, which derive half of their revenues from the region.
The resultant fallout of a slowdown has been a drop in IT spends by US companies, forcing Indian IT companies to offer bigger discounts to potential customers and re-price existing contracts at lower rates.
| EARNINGS UNDER PRESSURE | |||
| in Rs crore | FY08 | FY09E | FY10E |
| INFOSYS | |||
| Net sales | 16,692 | 21,664 | 22,637 |
| Net profit | 4,659 | 5,862 | 5,876 |
| EPS (Rs) | 81.31 | 102.31 | 102.55 |
| P/E (x) | 14.72 | 11.70 | 11.67 |
| TCS | |||
| Net sales | 22,862 | 28,241 | 30,492 |
| Net profit | 5,019 | 5,346 | 5,390 |
| EPS (Rs) | 51.27 | 54.60 | 55.06 |
| P/E (x) | 8.68 | 8.15 | 8.08 |
| WIPRO | |||
| Net sales | 19,743 | 25,392 | 26,987 |
| Net profit | 3,224 | 3,447 | 3,279 |
| EPS (Rs) | 22.17 | 23.71 | 22.55 |
| P/E (x) | 9.02 | 8.44 | 8.87 |
| HCL TECH* | |||
| Net sales | 7,639 | 10,441 | 11,375 |
| Net profit | 1,027 | 1,306 | 1,172 |
| EPS (Rs) | 15.37 | 19.54 | 17.54 |
| P/E (x) | 6.07 | 4.77 | 5.32 |
| * year ending is June 30. Source: Analyst Reports | |||
Plans by the US and other governments to discourage outsourcing will only make things worse. A sector that was once known to weather all storms returning robust numbers quarter after quarter is losing it’s sought after status.
Though the BSE IT index has performed relatively better than the BSE Sensex (down 45 per cent against Sensex’s 49 per cent decline) over the last one year, it is largely due to Infosys (down only 15 per cent), which has a 70 per cent weightage in the IT index. Even since December 1, 2008 till date, Infosys’ stock has been relatively flat, while the Sensex was down 6 per cent and the BSE IT index by about 18 per cent.
Among the few positives is the appreciation of dollar against the Indian rupee. Also, there are opportunities for Indian IT companies to cut down on their excesses, streamline their costs and venture into new segments and geographies. To know more on the road ahead for Indian IT companies, read on.
The bad news
As per a World Bank forecast, the world economy is set to grow at a modest 0.9 per cent in 2009, wherein the US, Euro region and Japan are said to contract by 0.5 per cent, 0.6 per cent and 0.1 per cent, respectively.
This indicates a tough business outlook for Indian IT companies, which derive about 85-90 per cent of business from these three regions. As per Forrester Research, the global IT purchases in currency adjusted terms would grow at 3 per cent in 2009 compared to 8 per cent in 2006.
The Central and Western European zones and the US are said to grow at 1 per cent and 2 per cent, respectively compared to 7 per cent in 2006.
Client issues
Most clients have been busy restructuring and pursing activities like acquisitions to combat the slowdown. This is having a negative impact on the big four Indian IT companies, which get 90 per cent of their business from existing clients. Says V Balakrishnan, CFO, Infosys Technologies, “We are seeing a delay in client spending – even from sanctioned budgets, as they are on a wait and watch mode. This has led to a lower velocity of business and is also contributing to the general slowdown.”
On an average, repeat business has been lower by around 200 basis points (bps) q-o-q to 91-97 per cent for the top four IT companies. Thus, overall revenue growth rates in Q3 FY09 have nearly halved q-o-q.
Going ahead, expect some curtailment in the discretionary spends (around 30 per cent of revenues) by customers. Analysts say that the compulsory spending in areas such as maintenance and processing will not experience major IT cuts as compared to new projects or initiatives such as software development.
Volume and pricing pressures
In addition to subdued repeat business, things have not been any better in terms of the number of new clients added, which dropped between 10-37 per cent y-o-y in Q3 FY09 for the top companies. What this also indicates that unlike the high growth rates seen in FY08, volume growth (on a declining curve and stood at 2-3 per cent in the latest quarter) will continue to be under pressure.
Nitin Padmanabhan, analyst, Centrum Broking expects the volume growth for Infosys to slip from 27.6 per cent in FY08 to 14.6 per cent in FY09E and further to 6 per cent in FY10E.
Going ahead, although clients have always wanted greater value for money, calls for pricing cut will become sharper when contracts are up for renewals. On cue, IT companies are also cutting rates to boost volumes or retain clients. Says Chirag Sanghani, analyst, Twenty First Century, “Pricing pressure could be in the range of 2-5 per cent. A third of the contacts come for renewal each year, so any decline in prices will be visible in the coming quarters with pricing pressure in CY09 and CY10.”
Cost-cutting measures
The proportion of fixed-price contracts (FPP) amongst the overall contracts has increased for Wipro (by 4.4 per cent), TCS and Infosys (over one per cent for both) on a q-o-q basis in the last two quarters.
Both, client and IT vendors have found preference for FPPs as it offers greater cost clarity and control (for clients) and ensuring revenue visibility (IT vendors). In addition to FPP, off-shoring is being preferred as it is relatively cheaper (costs are about a third) as compared to onsite. Little wonder that the share of off-shoring revenues has increased by 2-3 per cent in Q3 y-o-y.
When the rupee was appreciating in FY08, IT companies had started tightening sales, general and administrative (SG&A) expenditure, and this continues to show an improvement. In Q3, SG&A expenses as a percentage of revenue has decreased by 160 bps for Infosys and TCS as compared to Q2; on y-o-y basis it was down by 120 bps. For HCL Technologies though, it is up marginally.
The concerns over ramp-downs have also slowed the hiring plans of IT companies, which are hoping to improve utilisation levels. Says Manish Dugar, CFO, Wipro Technologies, “We have launched a series of initiatives to improve our cost-structure by increasing off-shoring, enhancing productivity, improving utilisation and cutting down expenses like travel etc.”
Down, but for how long?
In the last 13 months, US has lost 3.6 million jobs and unemployment rate is standing at a 25-year high of 8.1 per cent. This has led to calls from the US government to protect native jobs.
The increasing noise to curb outsourcing is not a good sign; the top four IT players derive between 50-65 per cent of their revenues from the US. However, in terms of the impact of these restrictions on the IT sector, an analyst from India Infoline says, “The recent proposals to limit tax breaks and block new H1B-based hiring for TARP (a government support initiative) receiving entities will have no material impact on Indian IT vendors; we are more worried about UK where calls are made to increase the bar on skilled immigrants.”
Balakrishnan further adds on how things would pan out on the outsourcing front. “Outsourcing has enhanced the competitiveness of US corporations and has created more jobs within the US. The US is a strong proponent of free trade globally. We are confident that it will not take any measures, which might hurt its competitiveness.”
Saving grace?
The silver lining in an otherwise gloomy demand outlook has been the depreciation of the rupee against the dollar. “The 11 per cent (average) rupee depreciation over the last two quarter vis-a-vis the dollar has aided the topline of the Indian IT vendors, which partially negated the pricing decline.
However, the depreciation of the British pound (16 per cent) and Euro (12 per cent) against dollar is a bane as it impacted the dollar term revenue growth,” says an IT analyst of Reliance Money. The revenues for IT companies in non-dollar currencies have been under pressure with a relative appreciation of dollar against most of the currencies.
The positive rub-off on the earnings front due to rupee’s depreciation is partially offset by hedging losses. The rupee’s appreciation during CY07 and early part of CY08 forced IT companies taking higher hedge positions to protect their revenue growth. The hedge positions were the highest in Q4 FY08 over the last many quarters.
Because of large hedges (TCS’s total hedge position is around $1.25 billion as on December 2008) companies could not take advantage of the depreciation in the rupee, leading to forex losses. For example, TCS’s forex losses have been around 18-21 per cent of net profits in Q2 and Q3.
Nevertheless, the depreciating rupee is a positive and with hedge positions decreasing (apart from Infosys which has a lower hedge position, hedges are down by around 40 per cent for the other three top companies) in the last three quarters, expect forex losses to be lower in Q4 FY09.
Challenges ahead
Analysts expect the next few quarters to be challenging, especially in verticals such as BFSI, manufacturing and telecom. Around 25-40 per cent of revenues come from the BFSI; the segment which has been most affected (due to global majors reporting losses and write-offs). However, pharma, media and retail have done well in Q3 FY09 and, could offer some respite.
While in the applications development and maintenance segment, the Indian IT sector has a market share of around 30 per cent, other segments like consulting and BPO (market share of 2.5-4 per cent) provide good opportunities for companies to scale up.
Newer markets such as West Asia, Latin and South America provide greater geographical diversification apart from the existing geographies. Several IT companies having cash in their books, would look at inorganic opportunities. And notably, the cost advantage enjoyed by the Indian IT industry should
