Margins have remained strong owing to lower overhead costs, higher employee utilization and INR depreciation

Margins have remained strong owing to lower overhead costs, higher employee utilization and INR depreciation

The Indian IT Services industry is expected to have short term adverse impact due to coronavirus outbreak.  The sector growth is expected to remain flattish in US$ terms in FY2021 (compared to previous estimate of nil to -3.0%). The relatively better performance has been led by higher demand for digital technologies. COVID-19 remains an ongoing concern, but enterprises have shifted to virtual models that have pushed the acceleration. The credit profile of Indian IT Services companies is expected to remain stable.

Explaining this further, Gaurav Jain, Vice President, ICRA says, “The global spread of the coronavirus has resulted in simultaneous supply and demand shocks. IT Services companies have managed to overcome supply led challenges through uninterrupted delivery of IT services, through work from home model however, the challenges on the demand front continue to persist. The US and the Eurozone which generates more than 80% of IT Services export revenues will see their GDP contract by 4.4% and 8.3% (Source: IMF, October 2020 Update) respectively in CY2020. The first half of FY2021 will also see impact in the form of price discounts and extended furlough requests by clients as they restructure their businesses. As a silver lining, the Covid-19 pandemic is accelerating the secular trends of core modernization, usage of collaborative technologies and cloud migration as companies shift to digital business models to pursue work from home model which will benefit IT Services companies.

During H1 FY2021, ICRA sample companies (13 companies) grew by 4.8% in INR terms while in US$ terms it grew by -2.3%, impacted by Covid-19 pandemic though supported by INR depreciation. In US$ terms, the growth has sequentially improved with US$ growth of -0.8% in Q2 FY2021 compared to -3.9% in Q1 FY2021. During H1 FY2021, INR depreciated by approximately 7.4%/8.0 Y-o-Y vis a vis US$/GBP which supported INR growth (USA and Europe collectively contribute 85% of ICRA sample set revenues). Deal wins as well as net employee additions has also shown improvement in Q2 FY2021 compared to Q1 FY2021. The net employee additions show positive trend with approximately 11,859 additions during Q2 FY2021 compared to -21,130 in Q1 FY2021 and -5,379 in Q4 FY2020 for our sample set of companies.

In terms of verticals, BFSI (30% of revenues) growth is slowing down over the last few quarters with FY2020 and H1 FY2021 growth of 6.8% and 6.2% respectively. The demand for the sector has been adversely impacted by current macroeconomic conditions impacting the banking industry including sustained low interest rates, continued focus on cost optimization, managing their discretionary spends as well as insourcing by few clients for want of greater control. The BFSI vertical will be further impacted owing to Covid-19 induced fiscal and monetary policies leading to lower interest rates impacting margins coupled with impact of coronavirus on economic growth, lower credit offtake and other banking services. The BFS segment growth is supported by digitization efforts, cost optimization, regulatory, compliance and security driven initiatives.

Manufacturing sector which has been one of the key growth drivers would be adversely hit due to lower consumption with decline of -15.1% seen in H1 FY2021. Travel and Hospitality followed by discretionary retail are impacted as consumers will restrict outdoor activities to essentials in the foreseeable future. However, Life Sciences vertical is expected to see stable demand; the demand for technology vertical would be strong owing to core modernization and cloud adoption as companies shift to digital models led by compulsory work from home.

During H1 FY2021, operating margins has improved to 23.8% from 22.7% in H1 FY2020 led by multiple factors. Lower overhead cost (travel, administrative), improved employee utilisation, higher share of fixed price contracts and INR depreciation primarily contributed to margin improvement. Uncertainty prevails over proposed changes (issued October 2020) include revising definition of occupations and positions qualifying for H-1B visa, increasing minimum wage level and reducing tenure for onsite third-party employee H-1B visa categories from 3 years to 1 year as the same have been currently put on hold as per Court order. As per our assessment of the provisions, if implemented in current form and without considering the increase in realisations or other mitigating factors – the gross impact of all the provisions will be in the range of 285-650 basis points on operating margins.

“The FY2019-2022e CAGR is expected to be around 6%-9% in INR for the Indian IT Services companies compared to CAGR of 10.5% experienced over the FY2016-2020 period. With aggregate operating margins of ICRA sample set at 22.7% in FY2020 coupled with moderate capex (organic as well as inorganic) and working capital requirements, the free cash flows have remained robust historically. Margins will be supported by factors such as ability to modify cost structure with variablisation of salaries & gradual reduction of high cost resources; deployment of operating levers such as higher share of fixed price contracts, lesser idle resources & automation benefits. However, these factors will provide limited cushion leading to slight decline in operating margins from 23.5% in FY2021e to 22.5% in FY2023e. The credit profile is also supported by net cash position with significant liquidity in the form of surplus investments generated out of past cash flows. Our sample set of 13 leading Indian IT Services companies reported surplus liquidity (net of debt) of approximately Rs. 1,652 billion as on March 2020 despite healthy dividend pay-out in addition to share buybacks in FY2020.”