IT stocks fell further on Thursday, as investors continued to believe that pricing pressures for the sector are far from over. Shares in the sector fell sharply on Wednesday after Infosys Chief Operating Officer Pravin Rao told Moneycontrol in an interview, “The traditional core business is seeing huge commoditisation and pricing pressure. Clients are throwing open for rebidding most of the deals that are coming up for renewal and asking for 20-30 percent cost take-out. While you may have been a successful partner, clients are asking for a cost reduction of 20-30 percent due to commoditisation of traditional core services.”
While the company attempted to do damage control by evening on Wednesday, it could not calm the nerves of investors. Sumeet Jain and Saurabh Thadani of Goldman Sachs put a ‘sell’ rating on Infosys in a note titled “Pricing pressures far from over…”.
Analysts say that while pricing pressure and growth pangs of Tier I players are known, what shocked investors was the cost take-out figure of 20-30 percent that Rao shared with Moneycontrol in the morning.
The S&P BSE Information Technology index was down 1.4 percent, underperforming a flat Sensex. The BSE IT index fell nearly 2 percent on Wednesday.
Says Jigar Shah, CEO, Kim Eng Securities, “There is no doubt that there is huge pressure on traditional business. Clients are asking to do more for less. With client IT budgets fixed, they are looking at taking out cost from traditional services to deploy it in digital transformation and big data analytics and adopting cloud and software-as-a-service models. [The question as to] whether or not pricing pressure will be there due to cost take-out has no straight answer as there are thousands of projects. Business models will also migrate. The question company needs to answer is how will the decline in the existing business be offset.”
Also, a lot of time and material (per hour billing) projects are now becoming fixed-price and companies have levers to bring down costs. While IT companies do have multiple levers to maintain pricing, the actual decline in the business needs to be compensated by the new transformative side of the business. According to Rao, this is not happening yet and may pick up pace in the next few years. Thus far, 70-80 percent of work done by Indian IT companies has been on the traditional legacy business (maintenance, application & development) and the transformation work is happening at a smaller scale and smaller contract sizes, explains Shah.
Emkay Global has been flagging off pricing pressure on Tier I companies for a while now. The brokerage hosted a senior consultant for his views on the current state of the industry. Quoting the consultant, Emkay in its note dated May 2017 said: “He reckons that Indian IT players would need to go through a reset in their margin profile over the next few years as they build up both domain/delivery capabilities in the new areas. He believes that the EBIT margins for players like Infosys and TCS at 25 percent/26 percent, respectively are the most vulnerable in this scenario.”
Clearly, be it growth rates, pricing or margins, the best is behind Indian IT industry. While the market is divided on pricing and the immediate impact on cost take-outs, it is evident that the challenges faced by the large legacy players like Wipro, Infosys and TCS are greater than those faced by smaller peers. While actual traditional business may shrink, companies may be able to maintain margins by improving efficiencies and productivity by offshoring more and automating. But there is no doubt that actual contraction in business will need to be compensated. Says one analyst with a large domestic brokerage firm, “Typically, when the client is seeking a cost take-out, they compensate by giving equal proportion of new business to the vendor. But if that is not happening then it is a concern."
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