The COVID-19 pandemic brought the world to a halt and left uncertainties, pushing the world to a global lockdown. Technology is one thing that came to rescue and proved to be a boon in these challenging times as it made life easy in many ways.
The IT sector has witnessed an unprecedented demand for online banking, online shopping, other digital platforms like entertainment, business etc. Digital transformation and migration to cloud became the need of the hour as it made accessing and maintaining data from remote places easier and quicker.
Indian IT companies once again established the strength of their business model. Operating under challenging circumstances, IT companies managed to improve margin and free cash flow (DSO improvement) despite extending pricing discounts and credit lines to select few clients, whose business models were completely disrupted.
Low-cost offshore delivery centres would further help their clients to reduce total cost of ownership for IT. We are expecting minimal impact of the COVID -19 pandemic to the IT services due to healthy deal pipelines.
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Due to demand and supply side challenges across geographies in the previous quarter, dollar revenue for Indian IT companies in Q1 declined. We expect recovery in Q2, with stronger FY22 led by 1) abated supply side challenges 2) strong exit rate 3) demand recovery with deal wins during the quarter showing no major disruption and pipeline regaining pre-COVID levels. However, the sales cycle continues to be slow. We expect Indian IT companies to grow at 0.5-1.5 percent in FY21E and 7.5-8 percent in FY22E.
However, despite macroeconomic challenges, Indian IT companies posted stronger operating margins in Q1FY21 aided by superior cost management, lower travel cost and INR depreciation, resulting in margin resilience despite weak revenue and pricing pressure. Indian IT services companies are successful in adopting new business models and transform themselves to work-from-home (WFH) without disturbing the deliverables.
We expect the margin to improve gradually hereon as revenue recovers, while there may be headwinds like travel, marketing cost etc. Indian IT companies are gravitating towards a sustainable WFH delivery and extreme off-shoring model which would be margin accretive. We expect IT companies to deliver EBIT margin of 21.0-22 percent in FY21E.
North America is one of the major geographies that contributes around 60 percent to the topline of most of Indian IT services companies. IT spending in North America started gaining momentum and the demand scenario remained resilient despite challenging macroeconomic conditions. However, US elections may have some impact on allocation towards IT spends by companies in the near term. We remain cautiously optimistic on the US business from an overall perspective.
Europe is the second largest geography that contributes around 30 percent of the total revenues. Most of the IT services companies in India see a positive movement in Europe. We expect traction in European banking, while UK banking is expected to be under pressure.
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BFSI is one of the major sectors that contribute significantly to most IT services companies in India. BFSI is going to witness quicker recovery as compared to other verticals. BFSI revenue was largely impacted in the UK and Canada due to supply-side issues from early April. Revenue held up relatively well in other markets. A majority of managements of Indian IT companies expects recovery in BFSI led by revival in Capital markets and European banking. UK banking is expected to be soft, while US banking is expected to revive from Q3FY21.
Communications and Media was pulled down by the media sub-vertical which was impacted by cancellation of major sporting and entertainment events and the resultant impact on advertising spends. We believe there will be a gradual pick-up in demand for 5G networks from forthcoming quarter as economies start reopening.
Retail vertical has seen significant impact due to the COVID-19 pandemic and global lockdown. Retail was the most impacted by the virtual shuttering of many retail segments as well as the travel sub-vertical. A few sub-segments like Grocery and Pharmacy Retail and CPG performed well during the quarter.
We believe a sustained growth in the IT Services sector aided by robust demand for the services like cloud computing, IoT, business analytics and other digital business will help IT services to gain momentum in the long term.
The author is Senior Research Analyst, Axis Securities.
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