Pricing pressure on IT to drive consolidation

Street looks past near-term pressures on revenues, margins; focuses on opportunities

The outlook for India's software services companies has not been so promising in the past few quarters. While revenue growth has slowed, pricing pressures have not. The recent decline in the rupee is unlikely to hit margins materially. Infosys chief executive Vishal Sikka had conveyed similar concerns to investors earlier this month. Analysts believe while pressure on pricing is a risk to the information technology (IT) sector, opportunities are likely to emerge as competitive intensity increases.

Several small companies operating on low margins and having easily replicable models will come under tremendous pressure, which can aid revenue growth of bigger firms. While the top-four companies have the means to transform and scale up, smaller companies will have to give up ground to bigger ones, driving consolidation. The smaller firms might not change their business models and invest in digital capabilities to meet customers’ needs, putting a question mark on their existence. Bank of America Merrill Lynch has analysed 561 IT firms, of which 75 per cent have a net profit margin of less than 10 per cent. Forty-nine per cent have a net profitability of under five per cent.

  Larger vendors have the ability to offer lower price points on the basis of higher volumes. This would result in consolidation of sorts in the regular vanilla services segment. Bank of America Merrill Lynch expects the top-four Indian IT vendors to benefit from this trend of consolidation.

The pressure on margins needs to be viewed in the context of fresh investments being made to build capabilities in newer business lines. Dhananjay Sinha of Emkay Global explains: “There exists possible downside risks to growth expectations, while barring for a weak currency, the risks to margins is also on the downside, given the need to step up investments to build capabilities in digital as well as local/onshore delivery.”

Automation is the other lever that the Street expects IT companies to utilise to lower costs. Over five years, analysts expect revenues from automation to increase to 20 per cent by FY20 from the current one per cent. Over the past eight years, the annual revenues of the top-four IT companies have grown at 15.5 per cent, while the headcount has grown 14 per cent. By breaking the linearity of their business model, the headcount addition will also slow in the coming years. If automation is successfully deployed, it would have a positive impact on the financials of the top companies, as well as stock prices.