Shares of Indian information technology (IT) companies have taken a breather in the past three months, underperforming the markets by around 5%. This is on account of fresh concerns about the crisis in Europe and how this would affect growth beyond this fiscal. Still, valuations of the top companies in the sector are rich at 19-21 times estimated earnings for fiscal 2011.
To justify current valuations, these firms need to grow close to 20% on a sustained basis. In fiscal 2011, top firms are likely to end up with growth of around 20%, with pent-up demand in the system getting released. But the pertinent question is whether the growth is sustainable.
A recent report by JPMorgan Asia-Pacific Equity Research throws some light on this issue. The report points out that a large part of the IT spending currently is related to cost-cutting measures being employed by customers, and that this form of IT spending can provide only low double-digit (10-11%) growth on a sustained basis: “Labour arbitrage, without innovation in taking out costs, exhausts its utility fairly quickly and gets commoditized over time. After a point in time, incremental growth is likely to accrue in this type of work only from new clients/verticals.”
Graphic: Ahmed Raza Khan/Mint
In the next phase, large firms have offered services that involve cost and/or value-added transformation for clients. This involves consolidation work (such as that of data centres), restructuring of business processes and operations, converting capital expenditure into operating expenditure through solutions such as platform-based outsourcing and cloud computing.
Here, proactive investment is required by Indian IT firms, and JPMorgan analysts say that generally mid-cap companies haven’t been able to step up here. “(This form of work) is the most recent pie growing off a small base for the top 3 players, and, in our view, can contribute about 3-5% to annual growth for them. Currently, this phase is almost the sole preserve of the larger players in the industry as transformational advisory and change management skills are in rather short supply and availability of that is confined to select players.”
For growth to pick up beyond the mid-teens, a third type of IT services needs to be delivered. This is related to business expansion plans of clients and will kick in only when customers have visibility of growth and want to invest in technology to facilitate this growth.
Indian IT firms enjoyed high growth rates between fiscal 2005 and fiscal 2008 largely because clients engaged in business expansion plans and, hence, there was a demand for such work (also called discretionary spending).
JPMorgan analysts point out that during this period, Infosys Ltd’s average annual growth would have been just 24% without this form of work, instead of the reported 38% growth. They also note, “This spend will not return unless client firms grow top line (or at least enjoy visibility of higher demand to invest in growing their top line), which we believe is not yet happening.”
At current valuations, investors are pricing in a reasonable amount of revenue from business-expansion-related work. This could result in some disappointment, unless growth of the global economy picks up steam.
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