The Nifty IT index has outperformed the Nifty 50 in the past one month and is currently near its two-month highs, thanks to a weak rupee, which fell by a sharp 99 paise against the US dollar last Tuesday. A weak rupee typically provides near-term support to margins of information technology (IT) companies. Analysts estimate that margins tend to gain by 20-25 basis point for every 1 percent depreciation of the rupee against the US dollar. However, this time, it may be too early to think about any likely margin improvement.
Factors such as higher attrition, elevated sub-contracting costs and pricing pressures are likely to weigh on the margins of IT companies in the near term.
According to Aniket Pande, analyst at Prabhudas Lilldher, high attrition levels, supply-side issues in the US, rising sub-contracting costs, expenses of executing large deals and pricing pressure, mainly in the legacy business, among others would keep the operating margins of IT firms under check despite gains from rupee depreciation. Higher attrition levels also impact delivery and utilisation.
In fact, higher pricing pressures in legacy business and rising costs of delivery have been negating margin benefits from rupee depreciation over the last two years, highlights Nomura, which foresees a 40-200 basis point contraction in EBIT (earnings before interest and tax) margin of IT companies in FY20 over FY19.
The impact of sub-contracting cost on operating margin is expected to be more for tier-2 IT players such as Hexaware, L&T Infotech, Cyient, among others, given their higher dependence on sub-contracting, higher onsite presence, lower ability to attract local talent, say analysts.
Also, top companies like Tata Consultancy Services (TCS) are likely to focus on growth over margin given the challenging demand environment in key verticals i.e. banking, financial services and insurance (BFSI) and retail in the US and Europe. For instance, TCS, during its June 2019 quarter earnings, highlighted weakness in capital markets (in the US) and large banks (in Europe). Even the retail sector is expected to post subdued growth due to lower spending. Overall, revenue growth is likely to be modest in the near term. An expected slowdown in the US and other larger economies due to global trade wars is also an overhang.
However, the softer outlook may still not significantly hurt stock valuations of IT firms. Given the stress some other domestic sectors (auto, NBFCs, etc) are going through, IT may still be considered as defensive.