Although the global economy is yet to recover, the Indian IT services industry is likely to grow by 13-15 per cent (in dollar terms) in 2013-14 on the back of improved growth prospects in the U.S., the biggest market for the country’s IT services exports.

Growth will largely be volume-driven with continued pressure on billing rates amidst global macro-economic uncertainties. Nevertheless, the industry’s performance in 2013-14 will be an improvement over 2012-13 when growth (estimated at 10 per cent) plummeted in direct response to the sharp fall in IT spending in the developed economies following weak economic growth and the resultant macro-economic uncertainty.

Signs of improvement

Things have certainly been looking up for the industry since the quarter ended December 2012, with heartening signals such as better-than-expected volume growth, an increase in discretionary spending, quicker decision-making cycles, and positive comments from the management of most leading IT services firms.

However, pressures on billing rates continue to persist with blended realisations being flat to marginally negative on a sequential basis. Despite the short-term headwinds, we continue to be upbeat about the long-term prospects of the IT services exports.

We project India’s IT services exports will grow by 14 per cent compounded annual growth rate (CAGR) over the next five years.

Some of the factors that will propel growth are: a mature global offshore delivery model; the ability of Indian vendors to execute bigger projects; increased focus on new markets and developing capabilities in non-traditional service-lines; process innovation; and the inherent need of clients to reduce costs to remain competitive. An increase in the proportion of offshoring will be a major growth driver; offshoring today accounts for just around 11 per cent of global IT services spend. India’s market share will improve, albeit at a slower pace, with major competing countries being China, the Philippines, Mexico, Uruguay and Brazil.

As they grow, Indian IT vendors will also evolve; their service-line mix will eventually favour high-value services such as IMS and system integration, which would push up average billing rates. Additionally, focus on emerging trends such as cloud computing, mobility, social media and analytics is also expected to aid growth. The BFSI (banking, financial services, insurance) sector will continue to have a dominant share in Indian IT vendors’ total revenues, but we expect retail, healthcare, and utilities to witness faster growth compared to BFSI over the next few years. Growth in the telecom vertical will remain sluggish.

While the U.S. will remain the key geography, we believe that the geographic skew of IT services exports from India to the U.S. will gradually come down as Indian IT companies explore new geographies in Europe (particularly France and Germany) and the Asia-Pacific. In contrast to the U.S., European countries have in the past been slow to adopt outsourcing; besides, their sales cycles also tend to be longer. However, in recent years, these markets have also begun to warm up to Indian IT vendors, which are aggressively foraying into these regions.

Profitability

The industry’s profitability will come under strain in 2013-14. We estimate that earnings before interest, tax, depreciation and amortisation (EBITDA) margins will fall by 50-100 basis points during this fiscal, primarily led by the continuing pressure on dollar billing rates and wage hikes.

Wages are expected to go up by 8-10 per cent during 2013-14, higher than 6-8 per cent in the previous fiscal, as attrition rates bottom out in the wake of improving industry fundamentals.

Additionally, expected increase in onsite/local employee proportion will also pressurise margins. The downward pressure on margins will, to some extent, be counteracted by the sharp depreciation of the rupee.

While we expect the rupee to appreciate from the current levels, the sharp depreciation we have seen so far this fiscal will nevertheless benefit the industry.

Pressure on margins will also be alleviated by an expected improvement in the utilisation rate, as demand improves.

Immigration bill

A major concern in the near-term is the proposed U.S. immigration reform bill, which has the potential to threaten the Indian IT sector’s existing business model; margins will be affected as costs increase due to the spike in visa cost as well as increased local hiring. Restriction on placing employees on H1B and L1 visas at client sites will also hamper smooth operations.

To conclude, we are optimistic about the long-term prospects of the Indian IT services industry, despite the near-term headwinds. Companies which adapt quicker to changes in the market place, invest adequately in sales and marketing, and have flexible pricing policies will outperform the industry.

The author is Director, Crisil Research, a division of Crisil

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