Why Indian IT sector woes have just started

Global slowdown, Brexit, changing dynamics in sector take toll; woes likely to continue over next 1-1.5 years

The Indian IT industry continues to feel the heat on account of a global slowdown, Brexit and changing dynamics in the software sector. In a recent interaction at the JP Morgan Investor Summit, Infosys’ Chief Executive Officer, Vishal Sikka, said, “I can tell you that the second quarter will be better. But we are seeing some risks that could lead to a downward revision of the guidance because the environment has worsened as we have gone into the quarter.”

Infosys had lowered its guidance in July 2016; a further reduction within a span of three months highlights the fast deteriorating scenario in the market. Earlier TCS and Mindtree had lowered their guidance. Cognizant had already downgraded its guidance during the current calendar year and lowered profit expectation.

Sikka has not put a figure to the expected revision though reports say that the management is in the process of deciding the price band in which it will be able to perform for the full fiscal. Urmil Shah of IDBI Capital believes that there is a likelihood of a 50-100 basis point cut in the company’s revenue guidance.

However, the bigger problem is the duration of the slowdown, which is expected to continue over the next 1-1.5 years at least. Analysts from broking firm UBS recently met large- and mid-cap IT services companies, IT buyers and industry veterans in India for an update on the demand outlook over the near and medium term. A report by the UBS team highlights that the near-term demand outlook has clearly deteriorated, with increasing concerns voiced over IT budget cuts in 2017. There is also greater acknowledgement of medium-term revenue growth issues due to smaller deal sizes and on-going pricing pressure.

A stretched slowdown will start impacting margins, as companies will be compelled to bid lower to feed their manpower and get work. UBS reports that some industry participants suggested that operating margins could see a 2-3 per cent decline over the next one or two years. The key catalysts for such a fall could be pricing pressure, driven by competition and an increasing captive-centre presence; lack of a currency tailwind; increased investment; and changing deal structures where costs are front-loaded but efficiency gains are back-ended.

Performance pressure has already started building up in IT firms. Since assuming office, Sikka has lost six executive vice-presidents and eight senior vice-presidents. Interacting with analysts in Pune last month Sikka said, "I have to candidly say that some of the exits were related to performance." Besides growth, the biggest problem affecting Infosys was attrition, but this was at the lower to mid-level employees. Post Sikka taking the reins seniors are being pulled up.

Senior-level changes are affecting other companies too. Mindtree, the mid-sized IT company has lost two of its oldest senior employees. Two executive vice-presidents with over a decade of experience in the company have quit their position.

Pressure on IT company is also visible in their efforts in cutting cost. Cognizant, with 11 offices in India with 160,000 employees, has given two days a week work from home option to its employees in the support function.

The churning taking place in the industry and the cost cutting measures signify that companies are feeling the heat and taking measures to soften the impact. UBS says earnings of IT companies are yet to bottom out and stocks will see a slow grind downwards until FY17/18E consensus earnings expectations come down to single digits compared with current expectations for low-double-digit growth. In other words we have a long way to go till the bottom is visible; earnings guidance revision is just the beginning.