Despite 8.1 Percent USD Growth in 2QFY18, IT Players Register Lower 3 Percent Growth

The aggregate growth of Indian IT services companies (14 sample companies) was at 3.0 percent during 2QFY18 (8.1% in USD terms) compared to compounded annual growth rate (CAGR)of 17.1 percent experienced over the FY13–17 period and a 9.7 percent growth in last fiscal, FY17. The lower growth was due to the Rs. appreciating by approximately 4.0 percent versus USD during the quarter. As per an ICRA note, Indian IT services companies are expected to register CAGR in mid-to-high single digits for the period FY2017-2020e.

In terms of verticals, BFS growth has been muted over the last few quarters. Demand for the sector has been adversely impacted by current macroeconomic conditions impacting the industry including sustained low interest rates and weakening of British Pound as a result of Brexit referendum.  The business is supported by digitization efforts, cost optimization, regulatory, compliance, and security driven initiatives. The insurance sector has seen good growth and is supporting the overall growth for BFSI which contributes 30 percent of ICRA’s sample set revenues. The manufacturing verticals (17% of sample set revenues) outperformed other key verticals with 5.8 percent growth in 1QFY18 and 3.6 percent in 2QFY18 led by automation including internet of things, analytics, optimizing supply chain and enhancing distribution channel effectiveness.

As for margins, industry’s operating margins have moderated from 24-25 percent to 23-24 percent over the last few quarters.

With several IT services players, both local and international, chasing limited new opportunities, price led competition is likely to intensify and will negatively impact margins. The industry is driving efficiencies through deployment of operating levers such as higher share of fixed price contracts, lesser idle resources and automation benefits. However, these factors will provide limited cushion leading to overall decline in margins from 23.5 percent in FY17 to 21.2 percent in FY20e. IT services players profitability also remains sensitive to Rs. depreciation vis-a- vis major currencies such as USD, GBP, and EURO and the same too will have an impact.

The credit profile of Indian IT services companies is expected to remain stable underpinned by its ability to sustain free cash flows despite pressure on revenue growth and margins. With aggregate operating margins of ICRA sample set at 23.5 percent for FY17 and 23.0 percent for 1HFY18 coupled with moderate CapEx (organic as well as inorganic) and working capital requirements, the free cash flows have remained robust historically. Despite pressures on growth and margins over the medium term, free cash flows are expected to remain healthy, though there could be moderation in the quantum of such cash flows. 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 despite healthy dividend payout and share buybacks.

Over the next decade, ICRA also expects consolidation in the industry especially among small and mid-size players as margin pressure will intensify leading to lower returns for shareholders. Overall, the credit profile is expected to remain stable over the medium term led by IT services companies ability to sustain free cash flows despite pressure on growth and margins.  Geo-political issues restricting movement of skilled labor or increase in minimum salary requirement too will have negative impact on the sector outlook.