The year ahead for IT: Digital could separate the sheep from goats

Margin pressure

“The large and scaled Indian base providers will continue to experience head winds as digital cannibalizes their legacy business and challenges their profit margins,” said Peter Bendor-Samuel, chief executive at research firm Everest Group.

Digital is the vague term companies use to describe the work involving new and emerging technologies as clients look to modernise legacy technology and build newer capabilities to keep up with the rapid changes in skills.

TCS’ operating profit margin in the March-ended quarter rose 0.2 percent sequentially to 25.4 percent, while Infosys’ remained flat at 24.3 percent, and Wipro’s stood at 14.4 percent, 40 basis points lower than in the previous quarter, particularly because of the impact of two of its client going bankrupt. If this impact was not accounted for, Wipro’s operating margin would have been 16 percent.

Bendor-Samuel added that globally, this is an optimal business climate. In the US, Indian IT’s largest market, where new tax code changes have come into effect, businesses are eager to utilize some of this money to invest in digital transformation.

“This availability of capital is also perfectly timed to take advantage of the maturity of digital. After 5 years of experimentation, business is looking to modernize IT so that it can be help drive digital transformation at scale,” he said.

Late last year, the US Senate passed a tax reform that reduces headline federal corporate tax rate from 35 percent to 21 percent, aimed mainly at making US-based businesses more competitive. Although the move is largely expected to raise costs for the outsourcing model, it also meant that US-based companies are now more willing to invest in digital capabilities.

The labour arbitrage or offshoring model has helped Indian IT keep labour costs low by employing Indian engineers to serve clients based in other geographies.

In the past couple of years, there has been a rising protectionist sentiment across the globe, not just in the United States and the United Kingdom, but also in Europe and even parts of Asia. Visa rules pertaining to IT professionals were made more stringent, forcing Indian IT companies to hire locally and pay higher wages, which in turn impacted margins.

Also read: Trump admin makes H-1B visa approval tough; Indian firms to be impacted

Will you get an H-1B visa? It's anybody's guess, as applications exceed limit

The Everest Group estimates that just addressing this issue of hiring locally as a result of visa problems will cost Indian IT firms 3 percentage points in terms of operating margin. The only Indian firm that has already paid this price is Wipro.

“I am pessimistic on the margin outlook, this is likely to offset some of the enthusiasm for their stocks reducing the upward benefit that the modest increases in growth will drive,” said Bendor-Samuel.

Top order rejig in the offing

HCL Technologies, currently the fourth largest Indian IT services firm by revenue, will report its fourth quarter earnings on Wednesday, and is widely expected to overtake Wipro to become the third largest firm by revenue.

“HCL has had a nice multiyear run demonstrating a nice string of growth. This strong growth record has now positioned it to pass Wipro in sizes in the near future…(the) aggressiveness in winning creative transactions coupled with its willingness to leverage its balance sheet has been a significant factor in its accelerated growth over the last 3 years,” said Bendor-Samuel.

Last year, HCL posted an annual revenue growth of 11.9 percent, with revenue coming in at USD 6.98 billion. Wipro’s annual revenue last year grew just 4.6 percent to USD 8.06 billion.

HCL’s strengths include the fact that it values technical areas that have over a decade of value in them, has strong execution, and is extremely cost aggressive, according to Phil Fersht, CEO at research firm HfS Research. Where it lags behind is marketing, in which it is “extremely weak and struggles to convey to industry the direction and strategy of the firm,” Fersht said.

Wipro, plagued by the issues mentioned earlier, has had a bad run of late, but analysts aren’t dismissing the company just yet. “Revenue and profitability are not always an indicator of good performance,” said DD Mishra, research analyst at Gartner.

As firms venture into newer areas of technology that are likely to pay dividends in the future, they could end up cannibalising their own revenues.

“Wipro is also doing well and is much faster in terms of cannibalising its revenue,” added Mishra. (Its all positive in the long term. Its shirt term loss of revenue as a new revenue stream capability is built up)

As The Economist explains in this piece, “Planned cannibalisation is an anticipated loss in sales of an existing product as a result of the introduction of a new product in the same line.” In this case, it means that as Indian IT invests more in building new capabilities to cater to digital and emerging technologies, it might experience some loss of revenue in its traditional or legacy business.

According to Fersht, Wipro’s strengths lie in being “price competitive, hungry and good execution reputation”. Having suffered the impact of two large clients going bust, it now “needs to stay focused on its digital mission and make further acquisitions to round out capabilities.”

“Wipro has done a solid job upping its value proposition and focus around digital and should enjoy strong results in the next couple of quarters,” Fersht said.

What next?

All IT companies say digital technology - the move to new technologies such as cloud, artificial intelligence, big data, etc. - is the new growth frontier, but there is no universal definition of digital.

Competition in digital is however, not just among the large domestic players.

India-based IT firms also face a large challenge from its US-based and global peers. The likes of Cognizant, Accenture, Capgemini, and even IBM, work in the same space, and compete aggressively with their Indian counterparts.

“I predict TCS will perform the strongest, Cognizant will continue healthy growth. Infosys and Wipro will be stable but unspectacular. HCL could be the wild card and give them all a strong run for their money,” said Fersht.

Also, it is not just Indian firms who are competing in the digital space, which is developing for players across the board. This provides Indian firms with some amount of time to plan and execute a change in their business models.

According to Everest’s Bendor-Samuel, “in many cases there is not yet a scaled digital competitor who has mastered the new digital models. This is sheltering the Indian firms and giving them time to change. All of the firms are ably led and each of them understand the challenge and are working hard to reposition their firms to successfully compete and win in the new digital market place.”

TCS’ strength lies in its strong execution, aggressive pricing and being able to model large deals in the changing technology landscape. It continues to be a favourite of analysts and industry alike, but its lack of spending on acquisitions may hold it back in the digital race.

Infosys, which started focusing on products and platforms under previous CEO Vishal Sikka, now seems to be heading back to its bread-and-butter consulting and outsourcing business.

The new pricing models emerging from the digital business are not fixed on the basis of price, but are outcome or output based. At this point, it is not clear if the profit margin will be redistributed toward IP owners and away from the IT services companies.

“It is very unclear if they (Indian IT services firms) will be able to build or buy these assets as the software is a very different business model from services and the multiples and stock prices of these firms are likely out of reach of the services firms. This is a case of be careful for what you wish for,” said Bendor-Samuel.