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Nilekani: growing the business volumes of Infosys has not been a problem but margins have been put under pressure |
The Indian stock markets fundamentally reassessed Indian information technology stocks last month. Jolted by a sharp fall in profit margins and a profit warning for the next fiscal year from Infosys, the bellwether for Indian IT companies, the stock sank. The market capitalization of Indian IT stocks has shrunk by over a third this year to Rs662.8 billion ($14 billion) on April 24, tipping the 30-share Bombay Stock Exchange Sensex to a six-month low. That is likely to lead to the postponement of an initial public offering by Tata Consultancy Services, the biggest exporter of Indian software services, which has been trying to list for over a year now.
The heady growth of the Indian IT industry in the late 1990s attracted a large chunk of the $15.9 billion that foreign portfolio investors have invested in India, as well as about $2 billion that came in from foreign private-equity funds.
Rapid growth encouraged investors to ignore what ought to have been clear warning signals of an impending market adjustment: the economic slowdown in the US and Europe, the biggest markets for Indian IT services; the appreciation of the rupee against the dollar last year; and bad political news starting from the war-like situation with neighbouring Pakistan and continuing with the US-led invasion of Iraq and Sars. All this forced foreign buyers to cancel visits to the region, put off IT investment decisions and put the squeeze on their Indian IT vendors.
Jyoti Jaipuria, head of research at DSP Merrill Lynch, says: “The market was aware of the squeeze on margins, which fell over the last three quarters, but investors expected that growth in business volumes would compensate for that fall. They just did not expect such a sharp fall and so soon.”
Nasdaq-listed Infosys’s revenues rose by 39% in the fiscal year ended March, profits after tax grew by 18%, but operating margins shrank to 26% from 32%. That is not a bad performance in a tough market. Infosys managing director Nandan Nilekani said that growing business volumes was not an issue, but pricing pressure was intense as existing customers consolidated their IT vendors and forced down rates. The company’s guidance for fiscal 2004 is that earnings per share will grow by 11% when most investment bank research had estimated over twice that level.
Infosys shares plunged 37% in just two days. The carnage continued as Wipro and Satyam, both listed on US exchanges, and second-rung companies such as HCL Technologies, declared lower than expected growth in profits.
As the global slowdown began to take hold, some Indian companies moved into high-end businesses such as consulting. Most began moving more work offshore to where costs were lower. But profit margins were lower there too. The rupee’s 1% appreciation against the dollar last year was a further hit to margins.
Still, there was hope. Just as the software service market got sticky, the market for business process and IT service outsourcing started to take off. Call centres and back-office-processing companies sprang up almost overnight. While traditional software service exports grew by a modest 20% until December last year, exports of remote and outsourcing services grew by over 60%, according to a survey by the National Association of Software&Services Companies (Nasscom), the industry lobby group.
Foreign private-equity funds, such as Commonwealth Development Coporation Capital Partners (CDC), Chrysalis, Warburg Pincus, General Atlantic Partners and Citigroup Venture Capital, piled large amounts of cash into these companies.
Abhay Havildar, principal at General Atlantic Partners, says: “Global interest in outsourcing and offshoring business processes continues and Indian companies are well positioned to meet that demand. We find companies in customer relationship management, outsourcing and high-end IT services attractive.” Havildar’s US-based firm invested $100 million in Mumbai-based Patni Computer Systems in one of the biggest private-equity deals in the Asia-Pacific region last year.
Infosys set up Progeon, a transaction-processing subsidiary; Wipro acquired Spectramind, a leading remote-service company; and Mphasis set up Msource to capture the high growth offered by the industry. Managing an outsourcing business is different from writing software code, and more challenging.
“The business processing market is more price-driven so margins are low. But it is more sticky as it is difficult to shift contracts among vendors,” says Shahzad Dalal, vice-chairman, IL&FS Investment Managers.
Competitors start poaching It is also an intensely competitive business. GE Capital, HSBC, Citibank, JPMorgan Chase, Standard Chartered and ABN Amro have their own back-office processing centres in India. Several other global companies, such as IBM Global Services, Accenture, EDS, Ernst&Young Cap Gemini and Exxult have either set up or expanded operations in India in the past year. They use the same cheap Indian human resources that Indian companies employ, and their global brand names assure customers of global standards of service. These companies have already begun poaching managers and employees from Indian companies, pushing up employee salaries.
DSP Merrill’s Jaipuria points out: “For Accenture there is no barrier to entry in India. Hiring people is far easier than acquiring a customer franchise.” Indian companies will have to meet that challenge. As Mohandas Pai, who heads Progeon, which manages directory services for British Telecom, puts it: “We are competing with them [multinationals] on our home turf. We have mastered the global delivery model, our management is based in India and we know how to control costs.”
Indian IT vendors fear that job losses in mature economies are starting a political backlash against outsourcing to countries such as India. A proposed bill by the state of New Jersey that seeks to restrict outsourcing by the state government is on hold and employees of Indian IT companies have, in recent months, landed in legal trouble with local authorities in the Netherlands, Indonesia and Malaysia.
Analysts say the industry will mature, and though profits will be slimmer than in the past, IT stocks are still the best bet for foreign investors. With Sars threatening to trim growth in east Asia, the Indian market and IT story could still be interesting this year, they say.
From a P/E ratio of around 50 in the heady years, Infosys shares now trade at around 16 to 17 times forward earnings. “The market is looking for the right valuations now. Returns on IT stocks are still far better than those in other sectors,” says ILFS’s Dalal. Indian software and service exports grew 23% in dollar terms between April and December last year to $6.9 billion and Nasscom estimates say they touched $10 billion by the end of March.
As Indian IT companies adjust to the new reality, and the market revalues their shares, a new phase of restructuring and consolidation could begin. General Atlantic’s Havildar says: “Today it makes sense for larger companies to look to expand both internally and through an acquisition. Adding new services, product capabilities and regional presence are critical to offering clients as full-service a solution as possible.” Mphasis announced the acquisition of Shanghai-based Navion Software from Capital One late last year and on April 24 Wipro said it would acquire NerveWire, a Boston-based business and IT consulting company, for around $18.7 million in cash.
Sujoy Chohan, research director at Gartner, says: “Indian IT companies invented the offshore IT service model and got a huge premium for being an early mover.” Now that competition has pushed them to the wall in their own backyard, it is time for the boys to be men.
