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Bullish On IT

Radhakrishnan, fund manager, Franklin Templeton says that IT revenue growth will stay robust through 2011….

Though the IT sector’s performance in the March 2011 quarter was subdued, its prospects remain bright. Anand Radhakrishnan, senior vice president and portfolio manager-equity, Franklin Templeton Investments, who manages the Franklin Infotech Fund, discussed the prospects and problems of this sector in an interview with Mohammed Ekramul Haque.

In your view, how is the outlook for the IT sector in 2011? What are some of the positive and negative factors acting on this sector this year?

While most IT services companies reported rather subdued performance in the March 2011 quarter, the overall demand environment remains positive. Companies are expected to witness robust revenue growth throughout the current year. The key drivers of margin for IT companies will be pricing, utilisation rates and employee pyramid, if the rupee maintains its strengthening mode.

The performance divergence among companies could increase as reorganisation and management changes at some of the companies weigh in on performance over the short term. Some of the challenges impacting earnings performance across the sector include uncertain growth environment in developed economies and talent supply problems resulting in increased employee costs. Visa and regulatory troubles also need to be monitored, given the ongoing discussions for enforcing certain tough regulations.

According to research firm Gartner, global IT spending is expected to increase by 5.6 per cent this year. Do you think that Indian IT companies will mirror this growth rate (in revenue terms), or do you see them growing faster?

The growth in global IT spending as projected by Gartner includes computing hardware, software, IT services and telecom. The software sector is expected to grow at a compounded annual growth rate of about 6.7 per cent and IT services segment at 4.7 per cent. We believe that large Indian IT companies in these sectors will be able to grow at an annual rate that will be in mid to high teens over the next five years. They will be helped by market share shifts in favour of India as well as expansion in the overall outsourcing pie.

Which are the verticals that are expected to drive growth?

Banking, financial services and insurance (BFSI) has been the dominant vertical in terms of revenue and growth. But increasingly verticals such as retail, healthcare and media are expected to drive growth in future. We also expect increased offshoring to take place in energy and utilities. Hence this vertical should also witness rapid growth.

Apart from this, any success in attempts by the industry to reinvent itself in terms of offering new services and foraying into new markets like cloud computing linked services, analytics, etc. will bump up the revenue growth trend.

Do you expect any disparity in the revenue growth numbers of tier one companies on the one hand and mid- and smaller ones on the other? If yes, in your opinion why will such a disparity exist?

A confluence of factors has resulted in the widening of the gap between the top and smaller players in the Indian IT services industry. Leading players in the industry have benefited from trends like vendor consolidation and have emerged stronger through the financial crisis. This has also added to their ability to acquire a greater share of the incremental increase in IT spending over the last year or so. By contrast, smaller players are facing difficulties due to rising wage pressures, limited services offerings, increased attrition and lower share of the increase in volumes after the financial crisis. The ability to attract talent and breadth and depth of management are some of their other limitations.

At the same time, top companies have been adopting multiple strategies including cost rationalisation, moving up the value chain (consulting), and increasing focus on strong economies in emerging markets to protect margins. Most of these firms have defended their margins quite well over the last few years, despite a challenging environment. We expect this trend to continue in the times to come. Besides, we also believe that the performance divergence among various frontline companies could increase as some of them look to reorganise themselves and induct new management.

Having said that, some of the mid-sized players with differentiated niche offerings should be able to match or outpace the growth at the tier one companies.

There is talk of pricing increase of around 3-5 per cent happening this year. On the ground, what kind of price increase do you see? And from which quarter will this price increase start getting reflected in players’ results?

The price increases this year are unlikely to be very significant and will largely be a continuation of a trend that started in 2010, marking a recovery from the lows touched following the global financial crisis. However, players with superior product and service mix will have greater pricing power and they stand to benefit from the improvement in IT spending outlook.

A lot will depend on the growth in developed economies. Recent data points towards improved economic climate in the US and this could potentially lead to additional IT spending. Having said that, the pricing environment is likely to vary. The recent TPI index1 for the first quarter of 2011 showed that new scope signings2 were steady y-o-y, while the total contract value for the broader market declined due to restructuring contracts. The latter category is likely to be dominated by large MNC vendors, while the new scope signings will be relevant for Indian players.

What kind of impact does every one rupee appreciation have on Indian IT companies?

In FY11, the rupee appreciated by around 4 per cent and is estimated to have had an impact in the range of 120-200 basis points (bps) on margins. A 2 per cent appreciation in the rupee is expected to impact margins by around 50-100 bps. Various levers such as pricing, utilisation rates and employee pyramid along with forex hedging are used to mitigate the impact of rupee appreciation on margins.

How do you see the rupee moving during the current financial year?

In our view, the rupee is likely to be range-bound during the current financial year with the direction being influenced mainly by the movement in crude oil prices and foreign fund flows into the country. A lot will depend on macro events such as the EU sovereign crisis or other geopolitical events, which could lead to increased safe haven flows, thereby strengthening the US dollar.

How big is the opportunity in the domestic market? Which are the key verticals here, and how do you see those verticals growing in the next couple of years?

Gartner estimates that the domestic IT services market will grow to about $14 billion (63,000 crore) by 2014. BFSI is the largest vertical in the market and growth here has been driven by large demand for products like Finacle. Increased government spending in areas such as e-governance has also contributed sharply to growth. Still IT penetration in many verticals such as education and healthcare significantly lags behind international benchmarks and is expected to expand only over the longer term.

However, the domestic market is not high on the radar of some of the large IT players due to the relatively low billing rates and therefore lower gross margins when compared to overseas projects. Except for TCS and to an extent Wipro, most of the large players do not have a meaningful presence in the domestic IT market.

Does that open up the market then for mid- to smaller-sized domestic companies? Do they stand a better chance of winning local orders?

Given the pricing trends in the domestic market, many of the large players have been selective about the projects they vie for. The mid- and smaller-sized domestic IT companies have benefited from this and cater to corporate demand. However, the capability and scale of players is a key evaluation parameter for large government projects where some of the mid and small businesses find it difficult to compete due to lack of scale, capability and sheer size of the projects.

Indian companies have not moved into consulting in a significant way. How big is the opportunity and do you see any Indian company making significant headway in this vertical?

While the top Indian companies have ventured into the consulting space, the players have faced challenges in scaling their presence to meaningful levels. We believe it will be difficult for players to organically capture a share of this pie and that opportunities may be better captured through mergers and acquisitions. The consulting space is growing at the same pace as the rest of the market but the key here is the better pricing that players (35-50 per cent more than ADM3) are able to charge and the ability to break away from the conventional linear growth models (revenue linked to headcount).

Indian IT companies, especially the larger ones, manage a work force in excess of one lakh. Managing and retaining a talented work force is a major challenge for them. What are they doing to tackle this issue?

Companies have put in place a multi-pronged approach to talent engagement that includes employee-friendly policies, career enhancement programmes and ESOP plans to reward performance. Attrition rates, however, go through cyclical upturns and downturns reflecting the changes in business environment, but by and large are in line with the global industry average. In fact, the larger players have been able to manage and retain talent better than their smaller counterparts.

One needs to remember that companies like Accenture and IBM manage a much larger and culturally diversified workforce across a range of geographies and still have similar or lower attrition rates. In that sense, the challenges faced by Indian companies are not new.

How serious is the competition from other cost-effective outsourcing destinations like Philippines, Vietnam or even China? Should Indian IT start worrying?

India’s share of the global IT services market has expanded from being negligible to 5 per cent over the last decade. Simultaneously, other IT outsourcing destinations have emerged such as Eastern Europe, Mexico and countries like Philippines in Asia over the last decade or so. However, only Philippines has emerged as a strong contender and that too mainly in voice-based services market. Most other countries do not pose a serious business risk to India at this point of time. India retains its core advantages and is the only Asian nation to have any meaningful scale and momentum in the industry.

Chinese IT companies are more focused on their domestic markets and their service portfolios have not yet matured. Besides they lack scale. Note that despite the rise in competition, Indian players remain the most profitable among their peers and have emerged stronger in the downturn with their cost-saving strategies resulting in expansion in their margins.

Why is China not a bigger market for Indian IT? Do you see Indian IT companies making significant inroads into the Chinese market in the near future?

According to a study by KPMG, China’s total outsourcing market is expected to double from about $20 billion (90,000 crore) in 2009 to $43.9 billion (1,97,550 crore) by 2014. Indian IT companies have increasingly been expanding their presence in emerging markets including China. However, so far the operations of these companies are mainly focused on servicing their global clients that operate in the region and require services from established vendors. The domestic Chinese companies are catered to mainly by local players that have better understanding of their requirements and large Chinese companies typically have captive IT resources. A large share of the addressable market is government contracts and TCS is one of the companies that has made itself available, but has seen limited success so far. Infosys Technologies has also recently upped its presence in the market. It is setting up a campus in Shanghai and will more than triple its staff there.

1The Global TPI Index measures commercial outsourcing contracts valued at $25 million or more 2Scope signing. New contracts signed to replace current contracts 3ADM. Application development and maintenance