Turbulence in the global financial markets could translate into nasty surprises for the Indian software industry.
While the US government is trying to push through a $700 billion bailout package, the fallout of the collapse of marquee names in the US financial services sector spells trouble for the export-dependent Indian software sector.
Geographically, the sector gets over half of its revenues from the US, and based on verticals, a third of the total revenues flow from the BFSI segment. If the systemic financial collapse affects sentiment and growth of other sectors, then the IT sector could well face its toughest times since its many years.
The events of Wall Street have not escaped the attention of investors on Dalal Street who have hammered the IT scrips. The BSE IT index has underperformed the BSE Sensex over the last one year, with the former declining 30.3 per cent as against Sensex’s decline of 23.6 per cent.
In the last 15 days too, the IT index was down 15 per cent as compared to the Sensex’s decline of just 6.4 per cent. Notably, this underperformance comes even as the Indian rupee has seen a decline in its value against the US dollar in the recent past.
To know how these various developments are likely to impact the sector and companies, and what can be expected over the next one year, The Smart Investor spoke to various industry and investment experts.
Most IT companies, however, did not offer any comment citing ‘silent period before quarterly results’. To know more on the sector and companies, read on.
The immediate blow
Experts feel that Tata Consultancy Services (TCS), which gets 43.6 per cent from the BFSI segment and is estimated to be generating about 3.5 per cent of its total revenues from Lehman Brothers, Merrill Lynch and AIG, would be the most affected.
Among the other notable exposures to these troubled financial institutions, it is estimated that each, Infosys and Satyam, earn about two per cent of their total revenues from AIG and Merrill Lynch, while Wipro’s exposure to Lehman Brothers is estimated to be about half a per cent.
“Indian tech firms might not be too affected by the exposure to these institutions. But, it is the indirect impact on growth trajectory of the technology service providers, that is worrying,” asserts Viju George, analyst, Edelweiss Securities.
Nevertheless, until the companies spell out the numbers (which should hopefully come out with their Q2 results), the markets will have little option but to keep guessing the quantum of skeletons.
Demand slowdown
The Indian IT vendors have been facing challenging times as a result of uncertainty in the US and Europe for well over a year now.
Six months after Bear Sterns went under and was acquired by JP Morgan, the latest series of events in the US financial sector would further slow down the demand for IT services. Expect the $1-1.5 billion that Lehman Brothers typically spends on its IT networks annually, to be cut by at least half as its bidder, Barclays, tries to rationalise and reduce overlaps.
Explains Som Mittal, president of the domestic software industry body, National Association of Software and Service Companies (Nasscom), “In IT budgets, the non-discretionary spend, which is about 70 per cent, will continue. In a downturn, discretionary spend on new projects, innovation or upgradation gets affected. The impact, if any, will be on the latter.”
Unfortunately, the economic slowdown has been catching up with the other verticals as well, namely telecom, retail and manufacturing, especially the automobile segment.
According to A Balasubramaniam, CIO, Birla Sun Life Mutual Fund, who also oversees the IT-specific Millenium Fund, some of the damage control measures by the US may make matters worse for Indian IT companies.
“Mortgage companies like Freddie Mac, Fannie Mae and now AIG getting nationalised is bad news for the Indian IT companies as the outsourcing could be reduced due to political interests.”
Europe no different
America’s transatlantic cousin, too, has a few problems of its own. Experts are of the opinion that markets in the UK and Spain could be the next to collapse as real estate prices have been on the decline.
“Companies like UBS and Deutsche Bank have already reduced their IT budgets,” says an analyst with a domestic broking house. The situation is not as bad as the US, but that is hardly any consolation. “Europe is clearly showing signs of slowdown, especially large economies such as the UK and Germany. They could very easily get into a recessionary phase,” believes Gaurav Dua, head of research, Sharekhan.
Among large American and European companies surveyed by IT consulting firm Forrester Research in September, a full 43 per cent have cut their overall spending on technology products and services in 2008. And, this was before the collapse of Lehman Brothers.
Competition to increase
IT companies maintain that they aren’t really feeling the pricing pressure yet. “There have been sporadic cases where the client has come back to us, to renegotiate the prices. But, on the whole, the pricing discipline is intact,” confirmed a CFO of one of India’s largest IT companies.
But, analysts believe that sales cycles are bound to get longer and it is a matter of time, before the companies feel the pricing pinch too. With consolidation taking place in the US financial sector at the moment, competition is likely to further increase between IT vendors.
Take for instance Bank of America (BoA), which would need two sets of IT vendors after buying out Merrill Lynch. Analysts say that BoA is an important client for Infosys, which places the latter in a relatively advantageous position compared to TCS and Satyam, which were IT outsourcing partners for Merrill Lynch.
The silver lining
The conversion of Goldman Sachs and Morgan Stanley into regulated commercial banks from brokerage houses could be a blessing in disguise. That is because commercial banks are bigger spenders on IT than investment banks.
“Commercial banks have a list of statutory provisions and compliance requirements to adhere to. This has been the highest spending areas for banks for the last couple of years. So, Goldman Sachs and Morgan Stanley could bring more business to IT companies,” pointed out an analyst. Tech firms, too, are harping on the now clichéd argument that the current financial mess will provide an impetus to outsourcing as the BFSI majors are forced to cut costs and improve efficiencies.
Experts, however, opine that this will come with a lag. Anurag Purohit, analyst with Religare Securities says, “Even in the last slowdown, it was only in 2003-2004 that offshoring increased in a big way. This time around too, such changes will take time, despite the fact that India’s cost advantage continues to be intact.” Viju George seconds this. “When companies look to survive and keep their body and soul intact, outsourcing doesn’t top the list of priorities. It will eventually happen, nevertheless.”
Time to get leaner
On the operational front, the companies will try to protect their margins by condensing their hiring plans and increasing the utilisation rate (currently ranging between 70-75 per cent), hiring fewer laterals (individuals with work experience), moderating the growth in wages in the range of 8-12 per cent and keeping a check on their selling, general and administration (SG&A) expenses.
While the attrition rate across the industry stands at 13 per cent, analysts feel that the same could reduce by a couple of percentage points at least and aid the utilisation rate. Viju George points out that on-the-ground monitoring activity suggests that hiring has gone down by at least 20 per cent y-o-y. Firms have become very cautious and there are a number of instances where they have postponed the joining dates of new recruits.
From a strategic point of view, companies could move towards a more integrated business model catering to the entire spectrum of horizontals and verticals. More thrust is expected to be laid on the nearshoring (setting up offices nearer to the client), to tap conservative markets of Europe and Japan, where the penetration of Indian IT companies has been relatively lower.
Companies are likely to consolidate by gaining niche skills, scale and clientele and moving up the value chain from their bread-and-butter application development and maintenance (about 50-60 per cent of revenues) to high growth, high margin areas such as consulting, infrastructure management services, packaged implementation and engineering.
The recent move by Infosys and followed by HCL Technologies to acquire Axon Group, UK (a consulting company) is an indication of this trend.
| WHERE THE MONEY COMES FROM | ||||||||
| Geographical breakup (%) | Segment breakup (%) | |||||||
| US | Europe | Others | BFSI | Telecom | Mfg | Retail | Others | |
| Infosys | 62.0 | 28.1 | 9.9 | 35.7 | 21.6 | 14.7 | 11.8 | 16.2 |
| TCS | 55.1 | 29.0 | 15.9 | 43.6 | 17.4 | 12.7 | 7.7 | 18.6 |
| Wipro | 44.0 | 24.0 | 32.0 | 24.0 | 11.0 | 18.0 | 16.0 | 31.0 |
| Satyam | 60.3 | 20.6 | 19.1 | 22.9 | 22.5 | 24.0 |
22.5* | |
The rupee has been kind
The 7.3 per cent fall in the value of Indian rupee against the dollar since July 1, 2008 could not have come at a better time. A strong dollar is beneficial for exporters as it fetches them more of the local currency improving operating margins, as in the case of IT firms by about 35-40 bps (basis points; 100 bps is one percentage point).
However, for companies which have hedged their receivables, the benefits on account of rupee depreciation would be capped. Firms that have relatively lower forex hedges like Infosys and Satyam are expected to benefit the most, while HCL Technologies and Wipro could gather mark-to-market losses.
On the other hand, while it will help improve rupee earnings, the greenback’s rise against other currencies (8.4 per cent against the euro and 8.8 per cent against the pound) would mean a hit in dollar earnings, which will reflect in the US GAAP numbers of companies. For example, Infosys derives around 28 per cent of its revenues from these currencies (euro and pound).
Due to this, analysts feel that the company could miss its FY09 US dollar revenue growth guidance of 19-21 per cent by about 1.5-2 percentage points. (Rupee’s appreciation against the euro and pound has been marginal at less than one per cent since July 1).
On an average, analysts expect the net impact of currency movements to be positive to the tune to 1.5-2.5 percentage points at the operating level for Q2FY09 for most of the companies. But, for the full year ending March 2009, the profitability is likely to be under pressure and operating margins are expected to reduce by the same range due to the existing tough business environment.
Conclusion
With a series of bad news emanating from US, it would be wishful thinking that the worst is over. So far, the turmoil has had significant impact on investment banks, which are not the largest IT spenders. If commercial banks are hit, we have a bigger problem on our hands.
According to the US-based banking research firm, Institutional Risk Analytics, nearly 110 small banks and financial institutions could fail between now and July 2009. And until the pain is completely out of the system, it is difficult to expect that the investor sentiment will improve.
“Sentiments will change only when clarity on the client front emerges. And it is unlikely this will happen over the next two quarters,” thinks Amar Ambani, head of research, India Infoline. Analysts expect the IT budgets for the next calendar year to be pushed well beyond December.
Nasscom has forecasted that the country’s IT and BPO exports would grow at a slower pace of 25 per cent in the current fiscal, as compared to 29 per cent growth witnessed last year.
The industry body has expressed its concerns over the industry meeting the revenue (software exports) target of $60 billion by FY10, even as the long-term IT story and the case for outsourcing on account of skill sets, labour arbitrage and proven processes, remains intact.
Manoj Mohta, head of research, CRISIL puts up a brave front when he says that post US presidential elections and consolidation among the BFSI companies, the Indian IT industry should be back on track, in increasing its current market share of close to 12 per cent of total global offshore business.
He also believes that the industry will have to live with a stable 20 per cent growth rate and could well be a defensive sector in the long term.
Infosys Technologies
Infosys had projected that it will top Rs 5,229 crore for the current quarter, a growth of over 7.7 per cent quarter-on-quarter (q-o-q). While the company might well meet this number, markets will keenly watch out for guidance for the December quarter and its full year forecasts when the IT bellwether announces its Q2 numbers on October 10.
Operating profit margins (OPM) in the current quarter are expected to hover around the 30 per cent mark or improve as the company will not have to contend with higher quantum of wage hikes and visa costs that dented OPMs by 210 bps to 30.4 per cent in the June quarter and get the benefit of rupee depreciation due to lower hedges.
Given its hiring plans, utilisation rates are expected to hover around the 70 per cent mark achieved in the last quarter or drop lower. While BFSI and retail grew 4 per cent each in the previous quarter, going ahead this might be difficult to achieve.
At Rs 1,480, the scrip is trading at 14.4 times its FY09 earnings of Rs 100.50. While the price is reasonable, investors will get an opportunity to buy at lower levels due to the uncertainty prevailing over the credit crisis and market conditions.
| MUTED GROWTH | |||||||||||||||
| Rs crore | Infosys | TCS | Wipro | Satyam | HCL Tech | ||||||||||
| FY08 | FY09E | FY10E | FY08 | FY09E | FY10E | FY08 | FY09E | FY10E | FY08 | FY09E | FY10E | FY08 | FY09E* | FY10E* | |
| Net sales | 16695 | 21314 | 25087 | 23013 | 28161 | 33204 | 19781 | 25433 | 29831 | 8385 | 11338 | 13354 | 7544 | 9539 | 11080 |
| Net profit | 4619 | 5791 | 6472 | 5113 | 5878 | 6667 | 3262 | 3760 | 4371 | 1713 | 2237 | 2498 | 1278 | 1523 | 1664 |
| OPM (%) | 31.4 | 32.2 | 31.4 | 26.5 | 25.5 | 24.8 | 19.5 | 19.9 | 19.0 | 22.0 | 22.6 | 21.1 | 21.5 | 21.7 | 20.7 |
| EPS (Rs) | 80.7 | 100.5 | 112.9 | 52.2 | 59.9 | 67.9 | 22.4 | 25.8 | 29.8 | 25.4 | 33.1 | 36.5 | 18.9 | 22.6 | 24.2 |
| P/E | 17.9 | 14.4 | 12.8 | 12.9 | 11.3 | 9.9 | 15.4 | 13.4 | 11.5 | 12.7 | 9.7 | 8.8 | 11.3 | 9.4 | 8.8 |
| Source: Analyst estimates *: Financial year ending June 30 | |||||||||||||||
Tata Consultancy Services
The uncertainty in the US BFSI space and large dependence on clients from this sector means that TCS revenues might be impacted the most over the next few quarters.
In Q1, while most verticals saw growth, TCS’s BFSI segment saw a 130 bps drop q-o-q in revenues due to client issues. In this light, the Q2 numbers will provide an indication whether there is a trend emerging or not.
On the cost front, despite a 6 per cent rise in revenues, wage inflation and lower average billing rates meant that operating margins (in Q1) were marginally lower at 22.06 per cent, thanks to the cost containment programme, which saw SG&A expenses drop 4.3 per cent q-o-q.
While the company’s utilisation rate hovers around a healthy 74 per cent, a slowdown in the US which accounts for half of its revenues might require India’s largest IT employer to cut down on its hiring plans.
At Rs 676.45, the stock is trading at a reasonable 11.30 times its FY09 EPS estimate of Rs 59.90. But, given the uncertainties for the sector, this is a high-risk high-reward play.
Wipro
Wipro’s Q2 revenues are expected to grow by about 5.5 per cent q-o-q, while margins are expected to remain flat or negative due to wage hikes. The company has given dollar revenue guidance for IT services (74 per cent of revenues) of $1.09 billion (Rs 5,014 crore).
Unlike in the June quarter, when its consolidated topline grew 5 per cent to Rs 5,692 crore aided by rupee’s depreciation and a strong showing in the IT services space, the company is expected to post an Rs 90 crore forex loss due to a high proportion of hedges in September quarter.
Wipro’s sequential growth in the June quarter ironically came from the financials and retail verticals, which grew 5.5 per cent and 7.8 per cent, respectively.
The company has hedges of $2.6 billion to cover cash inflows over the next year with a third of it hedged for the current fiscal. Sluggish client addition (31 in Q1 FY09) and dip in revenue from new clients are a cause for concern. The positives: unlike the cross currency issues that plague Infosys, Wipro’s dollar revenues will be less affected due to lower non-dollar billings.
The company has made 14,000 offers for FY09 with 800 joining in the first quarter while the rest are expected to join in the quarters ahead. The company, with an employee utilisation at 75 per cent, uses its workforce more efficiently than its peers. At Rs 343, the stock is trading at 13.4 times its FY09 estimated earnings of Rs 25.80.
HCL Technologies
HCL Technologies (HCL) reported impressive set of numbers in Q4 FY08 (year ending in June) with revenue growth of 11.5 per cent q-o-q. For Q1 FY09 (ending September), the same is pegged at close to 7 per cent growth(rupee guidance). The company has forex forward covers of about $1.85 billion (equivalent to FY08 revenues).
In the coming quarter, the company is expected to book forex losses of close to Rs 100 crore. The losses would be lower than the previous quarter due to unwinding of contracts worth $540 million in 4Q FY08. HCL has still not managed to optimise its selection policy to improve its fresher-to-lateral hiring; this still remains heavily skewed towards laterals.
Also, its SG&A as a per cent of sales is over 16 per cent (highest among peers), which provides the company an opportunity to cut costs and reduce margin pressures.
Overall, the uncertainties related to the demand environment, relatively high currency hedges (inability to benefit from a depreciating rupee) and client-specific issues would continue to be a drag on the stock price in the medium-term.
Analysts suggest that HCL’s bid for Axon at 650 pence per share (Infosys’ bid of 600 pence) will have a marginally negative impact on earnings. This is because HCL would have to borrow part of the funds (part from surplus cash) required for the same.
Satyam Computer Services
Satyam Computer (Satyam) is expected to deliver a revenue growth of 9 per cent q-o-q in rupee terms and 6 per cent q-o-q in dollar terms, which is not exciting given that a part of it would be backend-growth (subdued performance in Q1 FY09). EBITDA margins should contract 150 bps to 22.6 per cent on account of salary hikes.
While the scenario is challenging in the US, Satyam is witnessing increased traction in its other markets like Asia Pacific and West Asia. The package implementation business is also witnessing good deal flow as compared to services like consulting. Cash on books is also about Rs 67 per share (close to 21 per cent of its market cap).
With the market believing that Satyam has a significant exposure to Merrill Lynch has resulted in the stock plummeting by over 20 per cent in the last two weeks, despite the fact that the company has one of lowest exposure in the BFSI space (23 per cent). While issues on demand side remain, analysts believe that the stock price reaction has been more than warranted.
