IT’s on track, declare some. Not really, say others. Of late, opinion is divided on the strategy adopted by Indian IT companies. While one set of investors criticise them for keeping cash idle and losing the race to global peers, the other set is glad that they are not setting foot in unknown territory but, instead, saving cash for a rainy day.
But what the second lot don’t seem to realise is that the global market for technology is changing at a rapid speed and Indian IT companies need to change and think ‘big’ to stay relevant. Already, export revenue growth has slowed to single digit (from 13.8 per cent in 2013-14 to 10.3 per cent 2015-16. In the current year, Nasscom estimates growth to be 8-10 per cent) and order book expansion is happening at snail’s pace.
If Indian companies do not do a ctrl+alt+delete of their conservative ways and log into digital and consulting capabilities, they can lose significant market share. Also, with protectionism raising its head, uncertainty has multiplied manifold, taking away the ‘defensive’ tag from IT stocks.
Against this background, it makes sense for investors to review thier portfolio of IT stocks.
Here’s a closer look at the key challenges the industry faces and how the big players are faring.
Visa overhang
Young software engineers in India have to let go of their US dream. The protectionist rhetoric has become louder in the US with the new President, Donald Trump.
Last month, Indian IT stocks nose-dived in bourses after the news of new legislation in the US to curtail H-1B visas and increase the minimum salary for these visa holders. While the legislation has not been passed yet, there is fear that it may crimp the Indian IT sector that takes a chunk of these visas every year.
Over 60 per cent of the revenue of the $150-billion-plus Indian IT industry is from exports to the US. Tech majors such as TCS, Infosys, Wipro, HCL Technologies and Tech Mahindra have 20 to 40 per cent of their employees onsite. According to investment firm CLSA, Tech Mahindra has the highest share of onsite employees (totally 39 per cent including 19 per cent in North America) and TCS has the least (totally 19 per cent including 10 per cent in America). Infosys has about 26 per cent of its employees working onsite (that includes 13 per cent in the US).
When it comes to filling slots in their US offices, most Indian tech companies prefer to send people across on H-1B visas, given the high cost of hiring employees locally. At TCS, for instance, only 35 per cent of the headcount in the US are locals, for Infosys it is 34 per cent. So, any visa fee hike by the US may impact margins of Indian IT companies significantly. There may be margin erosion of around 200-300 basis points over a period of time as all old visas too get renewed. Wipro and HCL Technologies are placed better. Of the total employees working onsite in the US, 50 per cent are locals for Wipro and 65 per cent are locals for HCL Technologies.
Indian IT companies have already begun scouting for talent locally in the US. TCS’ application for work visas in April 2016 was down by 30 per cent compared to the previous year. Experts say that given that there is shortage of skilled workforce in the US, there may not be any severe restrictions on issue of H-1B visas. A Nasscom report last year showed that 46 per cent of openings in STEM (Science, Technology, Engineering and Mathematics) jobs were vacant for more than a month in the US. But in view of the recent protectionist rhetoric in the US, Indian companies should try to make do with local manpower as much as possible.
Hit by automation
US dreams aside, finding an IT job here in India itself is going to be difficult for software engineers. In 2015-16, the Indian IT industry was expected to create 2.75 lakh jobs, but it created only 2 lakh jobs. In 2016-17, the number is expected to be even smaller — 1.7 lakh.
Slowing revenue growth alongside increasing pressure on profit margins is prompting tech companies to go slow on fresh hires. In the past five years, while IT exports have grown at an average 13.7 per cent annually, the headcount growth has only been 8 per cent. Companies have been able to do the same amount of work with less manpower, thanks to automation. A report from global outsourcing research company HfS Research says that by 2021, India could lose 6.4 lakh low-skilled positions in IT services and the BPO industry because of the automation of support and back-office processing work.
Though this is a dampener for a job aspirant, it is a big positive for an industry whose survival is being challenged, as costs come down. Infosys, saved 2,650 full-time employees worth of effort in the December 2016 quarter by deploying automation tools in application maintenance, package systems maintenance, BPO and Infrastructure Management. Many other IT companies including Wipro and HCL Technologies also report use of automation platform. In 2015-16, Wipro says it freed up 4,300 employees because of its automation and AI (artificial intelligence) platform. For 2016-17, while the company targets releasing 4,500 employees, in the first half of the year itself it released 4,300 employees through use of robotic process automation.
However, what you need to note here is that while on one side automation helps save costs, on the other side, it drags down revenue.
Revenue cannibalisation due to automation, though not a desired outcome, cannot be avoided. Indian IT companies have to be more proactive about convincing clients on automation and sharing the cost benefit with them, else there is risk of losing business to competitors.
Loss of revenue due to automation can be balanced only by growing revenue from new businesses in digital and related areas.
The digital challenge
The worldwide IT services market is forecast to grow 4.2 per cent in 2017, up from 3.9 per cent growth in 2016, fuelled by investments in the digital business, intelligent automation and innovation, according to Gartner. IDC, in fact, has predicted that by 2017, over 50 per cent of spends of organisations will be for third platform technologies, which refers to cloud computing, big data analytics, mobile computing and IoT (internet of things) and by 2018, at least half of the IT spending will be on cloud applications alone.
Indian IT exporters will be left out in the cold if they do not quickly adapt to the changing market. Over the last 7-8 years, the global tech sector has been making the shift from traditional to cutting-edge technologies to keep pace with customer demands. But Indian tech companies haven’t kept pace and so now, since they do not have a track record for large transformational projects, big clients choose to go with market leaders such as Accenture.
Data from HfS Research shows that of all the 371 deals of the 70 large and mid-size IT companies that it tracked in 2015, 137 were digital deals and over half of it was clinched by global IT service providers, including IBM (45 deals) and Accenture (16). India-centric service providers — Cognizant (8), Infosys (5), TCS (4) and Wipro (4) — won only a few deals. This trend has remained the same in 2016 too, says Pareekh Jain, Research VP, at HfS. “I see nothing has changed in the last one year, IBM and Accenture continue to win most deals. They invested very early in digital capabilities and have been able to take the lead…”
A recent Nasscom report states that digital revenues contribute 14 per cent of the Indian IT industry’s overall revenue. To grow the digital business, Indian companies will have to look at inorganic expansion. All MNC digital majors have done it only through M&As. Accenture, awhich sees 40 per cent revenue contribution from digital, cloud and security services, made more than a dozen acquisitions in 2016. Of these, several were in the digital space — Karmarama (UK), OCTO Technology (Paris), Allen International (UK), MOBGEN (the Netherlands), IMJ Corporation (Japan), dgroup (Germany).
Cognizant, too, was on an acquisition spree last year, with four of its five deals being in the digital consultancy side — Adaptra (Sydney), Idea Couture, ReD Associates (49 per cent stake) and KBACE Technologies.
But looking back at India, there have hardly been any acquisitions by IT service companies. Though they are sitting on piles of cash, they have not been open to inorganic expansion. TCS, for instance, has made only three major acquisitions in the last 10 years — E-Serve International, Citi Bank’s BPO arm, in 2008, the Pune-based Computational Research Laboratories in 2012 and Alti, an enterprise solutions provider from France, in 2013. In the same period, Infosys made seven acquisitions — three of which happened after Vishal Sikka took over as CEO in 2014 — Panaya, automation provider, Skava, a digital solutions provider and Noah Consulting, an information service management provider. Wipro, HCL Technologies and Tech Mahindra too went in for some acquisitions. However, if we count only digital deals, the number is less. Digital acquisitions in the last five years were just Wipro’s acquisition of Appirio in 2016 — a SaaS (software as a service) provider for $500 million and Designit — a design company for $95 million in 2015, PowerObjects by HCL Technologies (provider of Microsoft Dynamics CRM, in 2015, for $46 million), and Skava by Infosys (for $120 million).
Missing consulting
The market leaders in the global IT space today, be it Accenture, IBM or Cognizant Technology Solutions, have a strong consulting arm. Given that about 13 per cent of the overall IT services market is made of consulting and the segment is growing faster than the overall market (Gartner research), it cannot be ignored. Also, as consulting expertise is essential to win digital orders, there is an urgent need to invest in consultancy.
But Indian IT service companies have not built a consulting brand for themselves. Infosys’ Consulting and Package Implementation business contributes 30 per cent to the total revenue today — unchanged from five years back. Pure consulting revenue in this may be only about 10 per cent, say analysts. Infosys acquired Lodestone, a management consultancy firm in 2012, but it was only in 2015 that the company decided to merge Lodestone with its own small consultancy business and bring more focus on the consulting practice.
If you take TCS, the company reports revenue from consulting and enterprise solutions as one segment — which, in the recent December quarter, contributed 17 per cent to overall revenue. Wipro, HCL Technologies and Tech Mahindra also do some consulting work for their large clients with whom they have a longstanding relationship, but revenue is not reported separately. Today, all high-level strategic consulting business of clients go to large players such as Accenture, PwC, Deloitte, Boston and Cognizant.
But Indian IT players too have an opportunity, says a JP Morgan report. They can target the ‘ground-level’ projects in- digital re-architecting of IT systems, analytics, mobility, cloud computing and process re-engineering. Though deal sizes are small here, the deals are numerous, the report adds. Big players do not come in here as organisations look for cost-competitive players.
Indian IT companies have to take lessons from Cognizant’s success in consulting. In the last five years, the company has successfully built a standalone consulting practice because it didn’t shy away from investing. Analysts at JP Morgan point out that Cognizant’s success in consulting was also helped by the matrix structure of the organisation where consultants have dual responsibility to both the industry head as well as to the consulting practice’s head.
The obsession with cash
While the large technology players in the global market are on an acquisition spree, Indian IT majors are sitting on piles of cash. Last year (2015-16), TCS reported a total of ₹29,000 crore of liquid funds in its balance sheet. In the numbers reported for the nine months ending December 2016, the cash balance (with current investments) bloated further to ₹38,406 crore.
Similarly, Infosys (₹30,480 crore) and Wipro (₹30,000 crore) too have a large hoard of cash. In the table, you can see that the large Indian IT companies hold 30 to 40 per cent of their asset in the form of cash.
This stunts returns for shareholders as the cash is kept in bank deposits, government bonds or liquid mutual funds which generate poor returns. After a hue and cry from investors, TCS recently announced a buyback for ₹16,000 crore.
But the numbers show that the company has been very miserly. The buyback will use only about 40 per cent of the cash with the company. Also, since the offer is for only 5.6 crore shares and the total outstanding shares are 197 crore, there is not going to be any significant increase in EPS which can make the stock price go up post the buyback.
Infosys has been doing a better job when it comes to sharing profits with shareholders. The dividend pay-out ratio has increased from 30 per cent in 2011-12 to 40 per cent in 2013-14 and 50 per cent in 2015-16. Since 2007, it has made three bonus issues (in the ratio of 1:1). But that said, given that the stock performance of the company has been bad in the last five years relative to TCS, the total return (assuming dividend has been reinvested) is better for TCS compared to Infosys.
However, be it a buyback, a bonus or dividend, it is not as welcome as the company finding a way to deploy it back in the business as these IT companies enjoy a profit margin of 20 per cent plus.
India IT companies tottering in a little-growth environment should use their cash to grow inorganically.
So, why are they not proactively looking for acquisitions? One reason could be that promoters prefer holding cash as it is seen as the King. The second could be the fear of being unable to complete a successful integration. There is also the search for non-existent ‘value’ buys, which is mostly fruitless since digital deals typically take place at 3-4 times the sales outside India.
