ICRA: Margins Contract During Q1FY2020 Owing To Higher Onsite Hiring, Sub-Contracting Costs; FY2020 IT Services Growth To Remain At US$ 6-8%

Posted by ICRA

The profitability of IT services companies declined during Q1FY2020, on account higher employee expenses especially onsite led by fresh hiring, sub-contracting cost and cross currency movements. Employee expense increased to 61.7% in Q1FY2020 from 59.8% in Q1 FY2019 for ICRA’s sample of 13 companies. The operating margin during Q1FY2020 remained at 22.6% versus 23.3% Q1FY2018 and Q4FY2019 22.7%.  The share of fixed price contract improved to 58.5% Q1FY2020 compared to 57.5% in FY2018 while employee utilization levels remained flattish during the same period for sample companies, being two critical factors associated with generating operational efficiencies.

During Q1FY2020, ICRA sample companies grew by 10.3% in INR terms while in US$ terms it grew by approximately 7.4%. During the quarter INR depreciated by 3.7% Y-o-Y versus US$ and appreciated 1.9% and 2.1% versus GBP/EUR respectively (USA and Europe collectively contribute 85% of ICRA sample set revenues). Few companies reported higher deal wins during the quarter while net employee addition has remained stable during the quarter across majority of our sample companies, being signs of stable demand environment for IT Services sector. The net employee additions show positive trend with approximately 29,305 additions during Q1FY2020 compared to 22,245 in Q4FY2019 and 26,782 in Q1FY2019.

Says Gaurav Jain, Vice President – Corporate Ratings, ICRA, “Demand is being driven by scaling up of solutions built around Digital technologies (Mobility, Social, Cloud, Analytics and Automation). The hitherto traditional outsourcing services such as Custom Application maintenance face pricing pressure and ERP (Enterprise resource planning) applications are increasingly becoming consumer oriented – with application delivery mechanism shifting to cloud based environments. Adoption of digital technologies has reached inflexion point and is triggering large scale re-architecture programs.”

Among the sectors, Banking & Financial Services continues to see some weakness led by current macro-economic conditions including low interest rates. Continued focus on cost optimization, managing their discretionary spends as well as insourcing by few clients for want of greater control though Insurance vertical is supporting the overall growth for BFSI which contributes 30% of the ICRA sample revenues. The Telecom vertical is showing signs of recovery owing to 5G and allied infrastructure development.

With the visa issuance norms being tightened by restricting the entry of entry-level programmers, increasing compliance and evidence requirements adding to cost pressures and fewer issuance of H-1B visas, Indian companies have ramped up onshore hiring in USA. Higher onsite hiring is associated with higher wage bills and lower margins. The overall operating margins are estimated to decline from 22.4% in FY2019 to 21.5% in FY2020e for ICRA sample companies.

Despite pressure on growth and margins, the credit profile of Indian IT Services companies is expected to remain stable underpinned by its ability to sustain free 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. Our sample set reported surplus liquidity (net of debt) of approximately Rs. 1,580 billion March 2019 despite healthy dividend pay-out of approximately 34% (Rs. 298 billion) in addition to share buybacks (approximately Rs. 250 billion) in FY2019.

“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. Geo-Political issues restricting movement of skilled labour or increase in minimum salary requirement will have negative impact on the sector outlook,” adds Mr. Jain.―CT Bureau