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Supply constraints resolved but pandemic hurts IT services

The Indian IT Services industry is expected to have short term adverse impact due to coronavirus outbreak. The sector is expected to grow at -3% – Nil in FY2021 versus ICRA’s earlier expectation of 6-8%. With the slowdown in growth during the first half of FY2021, the margins will also be negatively impacted before a likely recovery in FY2022. However, the credit profile of Indian IT Services companies is expected to remain stable.

Explaining this further, Mr. 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 -8.0% and 10.2% (Source: IMF, June 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.

The IT Services companies achieved 90-95% target of work from home for majority of the IT Services players by April with seamless integration for Application, IMS and Analytics. The BFSI vertical was impacted due to required modification in confidentiality agreements with clients while Business Process Outsourcing (BPO) was impacted due to infrastructure constraints. On the supply side, Indian IT services will continue to face issues such as travel restrictions to developed countries. At the initial stages of projects, movement of labour at client’s site is essential while later the same can be managed remotely. New projects to be commissioned will be delayed by minimum of 3-6 months while projects in pipeline will also face delays. The temporary suspension of issuance of fresh H-1B visas and L-1 visas (inter-company transfer) till December 2020 in view of the impact of Covid-19 pandemic on US economy and employment will mildly impact Indian IT Services sector considering their high dependence on such visas though pandemic has anyways led to reduced travel requirements for the foreseeable future.

On the demand side, developed economies which contribute to majority of the revenues will see delayed off-take of scheduled new projects, reduced discretionary spend as well as overall lower spend owing to sluggish economic growth. The BFSI vertical (30% of sector revenues) which is already seeing weakness across US and Europe will be further impacted primarily owing to medium term impact of coronavirus on economic growth, low interest rate regime, lower credit off-take and other banking services. Other key sectors such as Oil and gas will be impacted because of record low crude oil prices leading to reduced discretionary spends by such companies. Manufacturing sector which has been one of the key growth drivers is also expected to be adversely hit due to overall lower consumption. Travel, Airlines and Hospitality followed by Retail will be impacted the most as consumers will restrict outdoor activities to essentials in the foreseeable future. Overall, ICRA expects the pace of new contract award to fall by at least 700-900 bps in CY2021.

As growth slows down during the first half of FY2021, the margins will be adversely impacted though ICRA expect them to gradually recover in FY2022. The margins for the Indian IT Services are already facing challenging operating environment characterised by continued pressure on commoditised IT services, wage inflation, higher onsite costs necessitated by visa curbs as well as lower discretionary spend by corporate. Further, as a part of review of H1-B visa programme, the US Government is likely to replace the lottery-based system with merit-based system giving priority to highest salary applicants. There were approximately 2,25,000 applications for 85,000 H-1B visas to be issued in FY2021 (October 2020 to September 2021) making the programme intensely competitive. On an average, Indian IT Services companies pay higher than the minimum wages as per ICRA research though the proposed change will lead to higher onshore hiring for mid-level programmers who may not qualify for the visas based on new rule. Indian IT companies had already ramped up entry-level programmers in the past owing to tighter H-1B visa regime by USA.

ICRA expects large size companies with diversified presence across sectors to manage such headwinds better compared to mid-size companies which have moderately high proportion of revenues coming from few sectors coupled with vendor consolidation exercise during Covid-19 benefitting such large size players. Nevertheless, 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 short term revenue growth and margins.

“With aggregate operating margins of ICRA sample set at 22.3% in FY2020 coupled with moderate capex (organic as well as inorganic) and working capital requirements, the free cash flows have remained robust historically. Despite flattish growth and margins pressure over the medium term, these factors are unlikely to impact the free cash flow generation ability of Indian IT Services companies 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. Our sample set (13 leading companies) will report surplus liquidity (net of debt) of approximately Rs. 1,644 billion March 2020 despite maintaining healthy dividend pay-out of approximately 60% of profits in addition to share buybacks,” adds Mr. Gaurav Jain.

-CT Bureau

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