Indian IT may face margin pressure till FY20

Infosys, Wipro margin dreams may remain aspirational

Indian IT service providers are likely to see their operating margins subdued for three years till financial year 2020, as they struggle to get better prices for traditional services and generate new business in digital and cloud that require expensive hires to work on client locations.

The pressure on Indian firms such as TCS, Wipro, Infosys and HCL Technologies increases as they fight global firms such as IBM, Accenture and Capgemini see improved business in emerging areas and generate better margins from a lower base, says a report by brokerage firm Prabhudas Lilladher.

The margins for Indian firms are between 20 and 26 per cent, which is substantially higher than what global firms such as IBM, Accenture and Capgemini earn. The struggle to retain margins means that ambitious targets set by Indian IT services majors like Infosys and Wipro, who expect margins to be 30 per cent and 23 per cent by 2020, could be an uphill task.

Infosys chief executive Vishal Sikka has set a goal to reach 30 per cent margins at a revenue of $20 billion by 2020. Cross-town rival Wipro's Abidali Neemuchwala set himself a 2020 target to achieve 23 per cent margin at a topline of $15 billion.

Reasons like continuous pricing pressure on traditional mainframe technology service and slow-paced growth in emerging technology business may turn out to be spoiler for large Indian IT services companies like Infosys, Wipro, TCS or others.

"Global IT services vendors have been showing a steady margin improvement, albeit on a low base. For example, HP enterprise EBIT margin came at 10.7 per cent for Q4FY16 as against 5.1 per cent in Q1FY16 (October year ending). On the contrary, Indian IT vendors are struggling to defend their already high EBIT margins. The margin trajectory for Indian IT companies remains tepid despite tailwinds from rupee depreciation during the the past six years. During FY14 and FY17E, Infosys EBIT margins remained relatively stable, while the other three tier-1 IT vendors showed erosion," wrote Madhu Babu, IT sector analyst at Lilladher in the report.

Babu further explained why Indian software exporters find it difficult to retain the operating margin despite staying much ahead of the global counterparts.

While Indian IT vendors have increased onsite investments and expanded onsite delivery centres; they have taken over the onsite headcount as part of deals, too. This apart, companies like Wipro,Tech Mahindra Mindtree have acquired onsite-centric firms to acquire new skills. "These factors, coupled with other operational headwinds such as pricing pressure, subcontracting expenses, led to Indian IT vendors struggle on margin front despite steep currency tailwinds as rupee depreciated by more than 45 per cent against US dollar in six years."

Dinesh Goel of technology research firm ISG says maintaining margin remains a challenge. "Even though Indian firms have been way ahead of global players in terms of margin and maintained it for many year, they may now see a pressure due to continued pricing pressure. It may also drop slightly for some companies."

Constraints on visas to send engineers to US may also result in higher subcontracting costs near-shore, points out Babu. Delay in integration of business and employees for acquisitions made by Indian firms have impacted the operating margin for a few in the industry.

Going forward, the margin number will also depend on the mix of old and new technology business, since the services industry is seeing higher in emerging technology like cloud, AI, machine learning, says Goel.

On the other hand, the Lilladher report says, Indian IT services stocks have stagnated with tepid absolute returns during the past three years, compared with the global IT services stocks. This can be attributed to the "lacklustre acquisition strategy" of Indian firms, unlike the global peers. "We believe that a good capital allocation could help companies in this phase of transition...tier-1 vendors should have a consistent and steady buyback plan."