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Home >Industry >Infotech >IT recovery graph mirrors that from an earlier crisis. Can it sustain?

For India’s IT services industry, the initial impact of covid and the recovery since has been almost identical to the impact during the global financial crisis (GFC). On both occasions, quarterly revenues dipped 6-7% immediately after the disruption and then rose 15-16% from the lows within a year of impact.

But the recovery after the global financial crisis sustained for a long period. In the following two years, quarterly revenues of Tata Consultancy Services Ltd, Infosys Ltd and Wipro Ltd had grown another 45%.

A moot question is whether such high growth rates can be expected this time around as well. While there is little doubt that growth will be high this fiscal, given the relatively low base of the previous fiscal, there are question marks on whether growth will sustain at high levels beyond FY22.

The impact of the covid crisis on IT firms' revenues has so far been nearly identical to that during the global financial crisis
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The impact of the covid crisis on IT firms' revenues has so far been nearly identical to that during the global financial crisis

To start with, Indian IT firms now operate at a much larger scale, and incremental dollar revenues needed are far higher for the same levels of growth. For instance, the three firms added $1.8 billion in quarterly revenues between March 2010 and March 2012 quarters for the roughly 45% growth. For the same percentage growth, these firms will need to add $5.2 billion in quarterly revenues in the next two years.

Indeed, growth projections by Kotak Institutional Equities for the three firms suggest a compounded quarterly revenue growth rate of less than 3% on an organic basis in the next two years, much lower than the 4.7% growth recorded by them between the March 2010 and March 2012 quarters.

Some analysts believe sustaining a quarterly average growth rate of around 2.5-3% for the next two years could itself be a tall order. “Growth in recent quarters is being driven by some mega deals won by large IT firms. These lift-shift-transform deals include a high component of onsite personnel costs that gets taken over by Indian firms. While these result in impressive revenue growth, they can potentially be margin-dilutive, and firms are likely to pursue such deals judiciously. As such, it doesn’t make sense to assume a recurrence of such deals, which means growth may slow down, especially after the low base effect wears out in June quarter," said an analyst at a domestic institutional brokerage.

Late last year, TCS announced the takeover of Postbank Systems AG (PBS), the captive IT service provider of Deutsche Bank AG, along with its 1,500 onsite employees. About a month later, Wipro announced it was taking over the IT units of Metro AG, the global wholesale major operating in the food-service distribution industry. Infosys announced a similar deal with Daimler AG, the German auto major. Since these deals involve a high onsite cost component, the impact on margins needs to be watched out for as well.

While the worry on margins is yet to play out, the March quarter results indicated that revenue expectations themselves may need to be toned down a bit. Three of the top five IT firms missed revenue estimates last quarter, with weakness persisting in some segments such as communications and retail. Of course, growth hasn’t moderated materially yet. “The demand environment continues to be healthy, evidenced by strong deal win TCV and another quarter of record hiring," said analysts at Kotak Institutional Equities. The total contract value, or TCV, of large deal-wins by Infosys, for instance, rose 57% last fiscal.

For India’s IT services industry, the initial impact of covid and the recovery since has been almost identical to the impact during the global financial crisis (GFC). On both occasions, quarterly revenues dipped 6-7% immediately after the disruption and then rose 15-16% from the lows within a year of impact.

But the recovery after the global financial crisis sustained for a long period. In the following two years, quarterly revenues of Tata Consultancy Services Ltd, Infosys Ltd and Wipro Ltd had grown another 45%.

A moot question is whether such high growth rates can be expected this time around as well. While there is little doubt that growth will be high this fiscal, given the relatively low base of the previous fiscal, there are question marks on whether growth will sustain at high levels beyond FY22.

To start with, Indian IT firms now operate at a much larger scale, and incremental dollar revenues needed are far higher for the same levels of growth. For instance, the three firms added $1.8 billion in quarterly revenues between March 2010 and March 2012 quarters for the roughly 45% growth. For the same percentage growth, these firms will need to add $5.2 billion in quarterly revenues in the next two years.

Indeed, growth projections by Kotak Institutional Equities for the three firms suggest a compounded quarterly revenue growth rate of less than 3% on an organic basis in the next two years, much lower than the 4.7% growth recorded by them between the March 2010 and March 2012 quarters.

Some analysts believe sustaining a quarterly average growth rate of around 2.5-3% for the next two years could itself be a tall order. “Growth in recent quarters is being driven by some mega deals won by large IT firms. These lift-shift-transform deals include a high component of onsite personnel costs that gets taken over by Indian firms. While these result in impressive revenue growth, they can potentially be margin-dilutive, and firms are likely to pursue such deals judiciously. As such, it doesn’t make sense to assume a recurrence of such deals, which means growth may slow down, especially after the low base effect wears out in June quarter," said an analyst at a domestic institutional brokerage.

Late last year, TCS announced the takeover of Postbank Systems AG (PBS), the captive IT service provider of Deutsche Bank AG, along with its 1,500 onsite employees. About a month later, Wipro announced it was taking over the IT units of Metro AG, the global wholesale major operating in the food-service distribution industry. Infosys announced a similar deal with Daimler AG, the German auto major. Since these deals involve a high onsite cost component, the impact on margins needs to be watched out for as well.

While the worry on margins is yet to play out, the March quarter results indicated that revenue expectations themselves may need to be toned down a bit. Three of the top five IT firms missed revenue estimates last quarter, with weakness persisting in some segments such as communications and retail. Of course, growth hasn’t moderated materially yet. “The demand environment continues to be healthy, evidenced by strong deal win TCV and another quarter of record hiring," said analysts at Kotak Institutional Equities. The total contract value, or TCV, of large deal-wins by Infosys, for instance, rose 57% last fiscal.

It is also important to note that Infosys has been a bit of an outlier, with its growth and deal wins far exceeding that of competition in the past year. The TCV of all deal wins signed by TCS and Mindtree, for example, grew 17% and 12%, respectively, in FY21. “Like most cycles, some firms will march ahead during this recovery. However, the way all IT stocks have risen, investors seem to expect nearly all firms to grow at a brisk pace. This is unreasonable. Mid-tier firms, for instance, can’t be expected to gain from the trend in large transformational deals that are lifting top-tier firms," said an analyst at another domestic institutional brokerage.

Indeed, even in the post-GFC recovery, TCS and HCL Technologies Ltd raced past rivals on the back of their strength in infrastructure management services. A rising tide may lift all boats, but some boats will fare better because their inherent strengths help address the needs of the marketplace better at that given point. The Nifty IT index is about 57% higher compared to its pre-pandemic highs, with mid-tier IT stocks joining the rally with gusto as well. Kotak, for instance, has a sell or reduce rating on nearly all of the mid-tier IT stocks it tracks, owing to their high valuations. Nearly all of them trade at valuations that are higher than those of Infosys.

Investors also seem to be ignoring supply-side pressures. Hiring was muted amid covid, and now with large deal wins, IT firms are rushing to hire for a relatively limited talent pool in the digital IT services space.

“Firms will still struggle with shortage of talent in digital skills, leading to war for talent. Training and reskilling programmes help but are not sufficient to meet the demand for hot skills and experienced digital talent such as senior cloud architects and data scientists. Supply for such talent is naturally constrained as adoption of cloud, AI and other new technologies is in early stages," said analysts at Kotak in a note to clients. Needless to say, this can put pressure on margins, over and above the pressure from the recently added onsite-heavy deals.

Despite these few concerns, IT stocks are flying high, mainly because of pressure on stocks of firms largely dependent on the Indian economy, which has been hit severely by the second covid wave. Post-pandemic gains in stocks of IT services firms listed overseas, such as Accenture Plc and Capgemini SA, have been relatively more modest.

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