 "IT companies need to re-engineer to deliver high returns")
The results season is still in early bird mode but a few trends have become apparent. One is that the valuation of the IT sector seems to have changed for the worse. Infosys and Wipro produced poor results and weak forecasts. MindTree saw a drop in profits. TCS met expectations but cut its dividend. HCL Tech beat expectations.
All these companies have seen a fall in share price. The sector index, the CNX IT, has seen a drop of 15 per cent in the past month. Of the individual companies, HCL Tech’s case is the most puzzling, since the stock registered higher margins and beat earnings estimates. But a large part of the gains came from infrastructure management services and the market doesn't see a big upside there.
Investors seem to be viewing IT prospects pessimistically. The industry is cyclical but it's non-correlated with the Indian economy because of its exposure to the US and other markets. This gave it excellent hedging characteristics in the past. It might not offer that sort of protection if the current bearish trend is sustained.
On the face of it, this is odd. The US economy is recovering, albeit slowly. The rupee is more likely to move down than up, thereby boosting export earnings. So, one would have expected the IT sector to continue looking like a good investment.
However, a couple of structural changes will impact the Indian IT services model. The model is essentially labour arbitrage – employing relatively cheap Indian coders and BPO workers. Revenue per employee doesn't grow fast in this model; it depends on more hires.
Cloud-based services have reduced the need for large IT service teams and will probably reduce low-level labour needs even further over the next few years. The old model of a large team doing an on-site implementation is now less common.
Public cloud services with a wide array of tools and plug-ins can handle the customisation needs of most small and medium enterprises. Even larger concerns with data security needs that obviate public cloud usage seem increasingly comfortable using systems developed by public cloud service providers to implement private clouds. In addition, India's edge in low-cost labour has been eroded — Vietnam and Phillipines are competitive.
Projections like these can be wildly wrong. But if these are genuine, persistent trends, the Indian IT services industry will need to adapt. This means much more uncertainty than a simple cyclical downturn. The big IT services companies will have to find ways to maximise revenue per employee, learn different skill-sets and rework margins. The market doesn't know how to value such a possible transformation. If it is happening, it's early days and there are no obvious leaders. There could be opportunity here but there's likely to be more sell-offs before the opportunities becomes apparent.
All these companies have seen a fall in share price. The sector index, the CNX IT, has seen a drop of 15 per cent in the past month. Of the individual companies, HCL Tech’s case is the most puzzling, since the stock registered higher margins and beat earnings estimates. But a large part of the gains came from infrastructure management services and the market doesn't see a big upside there.
Investors seem to be viewing IT prospects pessimistically. The industry is cyclical but it's non-correlated with the Indian economy because of its exposure to the US and other markets. This gave it excellent hedging characteristics in the past. It might not offer that sort of protection if the current bearish trend is sustained.
On the face of it, this is odd. The US economy is recovering, albeit slowly. The rupee is more likely to move down than up, thereby boosting export earnings. So, one would have expected the IT sector to continue looking like a good investment.
However, a couple of structural changes will impact the Indian IT services model. The model is essentially labour arbitrage – employing relatively cheap Indian coders and BPO workers. Revenue per employee doesn't grow fast in this model; it depends on more hires.
Cloud-based services have reduced the need for large IT service teams and will probably reduce low-level labour needs even further over the next few years. The old model of a large team doing an on-site implementation is now less common.
Public cloud services with a wide array of tools and plug-ins can handle the customisation needs of most small and medium enterprises. Even larger concerns with data security needs that obviate public cloud usage seem increasingly comfortable using systems developed by public cloud service providers to implement private clouds. In addition, India's edge in low-cost labour has been eroded — Vietnam and Phillipines are competitive.
Projections like these can be wildly wrong. But if these are genuine, persistent trends, the Indian IT services industry will need to adapt. This means much more uncertainty than a simple cyclical downturn. The big IT services companies will have to find ways to maximise revenue per employee, learn different skill-sets and rework margins. The market doesn't know how to value such a possible transformation. If it is happening, it's early days and there are no obvious leaders. There could be opportunity here but there's likely to be more sell-offs before the opportunities becomes apparent.
The author is a technical and equity analyst