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 revenue growth and margins. With aggregate operating margins of ICRA sample set at 23.5 percent for FY2017 coupled with moderate capex (organic as well as inorganic) and working capital requirements, the free cash flows have remained robust historically. Despite pressures on growth and margins over the medium term, free cash flows of Indian IT Services companies are expected to remain healthy, 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 despite healthy dividend payout and share buybacks.
According to Gaurav Jain, vice president, ICRA, “The growth of Indian IT Services companies is impacted by lower demand led by uncertain macro-economic environment, lower deal sizes in digital technologies, cloud adoption and high competitive intensity from local as well as international players. The growth will be supported by higher spend on digital technologies, continued cost benefit offered through outsourcing model as reflected in CY2016 USD growth of 6.2 percent of Global IT Services outsourcing market and market share gains. While companies have increased spending on digital technologies and awarding new contracts, the overall IT budgets have moderated leading to lower incremental spends. Indian IT Services players market share of Global IT Sourcing market stood at 67 percent in CY2016 (60 percent in CY2012), however incremental gains are expected to be at a slower pace. Indian IT Services companies are in the midst of re-orienting their business models focusing more on higher end services such as IT consulting and emerging technologies (digital) and have made considerable progress so far, though still lag behind international peers. We expect large Indian IT companies to grab a higher share of the digital services space over the next three years.”
Aggregate growth of our 21 sample companies stood at 3.8 percent during Q1FY2018 (7.0 percent in USD terms) compared to CAGR of 17.1 percent experienced over the FY2013-2017 period with FY2017 growth of 9.7 percent. During the quarter INR appreciated by approximately 3.7 percent versus USD leading to lower INR growth. ICRA estimates the FY2017-2020 CAGR (Compounded Annual Growth Rate) to remain in mid-to-high single digits for the Indian IT Services companies.
In terms of verticals, BFS growth is muted over the last few quarters. Demand for the sector has been adversely impacted by current macroeconomic conditions impacting the industry including sustained low interest rates and weakening of British Pound due to result of Brexit referendum. The business is supported by digitization efforts, cost optimization, regulatory, compliance and security driven initiatives. The Insurance sector has seen good growth and is supporting the overall growth for BFSI which contributes 30percent of our sample set revenues. The Manufacturing verticals (17 percent of ICRA sample set revenues) outperformed other key verticals with 6.1 percent growth in Q1FY2018 led by automation including internet of things, analytics, optimising supply chain and enhancing distribution channel effectiveness.
The Indian IT services industry operating margins have moderated from 24-25 percent to 23-24 percent over the last few quarters though remain healthy. Jain adds , “The margins for the Indian IT services companies will continue to reflect the challenging operating environment characterized by pricing pressure on commoditized IT services, wage inflation, higher onsite costs necessitated by visa curbs as well as lower discretionary spend by corporate. Several IT services players, both local and international, chasing limited new opportunities will intensify price led competition and will have a negative bearing on the margins of Indian IT Services players. The industry is driving efficiencies through deployment of operating levers such as higher share of fixed price contracts, lesser idle resources and automation benefits. However these factors will provide limited cushion leading to overall decline in margins from 23.5 percent in FY2017 to 21.2 percent in FY2020e. The profitability for Indian IT services players remains sensitive to INR depreciation vis-a-vis major currencies such as USD, GBP and EURO and the same will have a bearing same.”
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. Overall, the credit profile is expected to remain stable over the medium term led by IT Services companies to sustain free cash flows despite pressure on growth and margins though geo-political issues restricting movement of skilled labour or increase in minimum salary requirement will have negative impact on the sector outlook.