Margin fears in IT sector overplayed, say analysts

Is the Indian information technology (IT) industry at a turning point as far as margins are concerned?

It’s a scenario that everyone in the sector is visualising due to the rising wage inflation and price competition that could be set off with an imminent shakeout with the industry.

In all possibility, analysts say, the industry may take an about turn and return to its hey-days of margins. They say there are too many levers available to IT firms that could provide cushion to their margins and keep their current rate margins intact.

HSBC analyst Yogesh Aggarwal, for one, believes the margin apprehensions post the fourth quarter results are a wee bit overplayed.

“In our view, while the sector faces margin headwinds in the form of wage inflation — impacting margins by around 300 basis points (bps) — pricing improvement and conventional margin levers such as offshore transition, utilisation, SG&A (selling general and administration expenses) leverage and employee pyramid are likely to fully offset the wage inflation impact in fiscal 2012,” he wrote in his report brought out Thursday.

Fears on diminishing sector margins surfaced when Infosys Technologies, now Infosys Ltd, reported a sequential slip of 1.2% in its operating margin in the March quarter - first in seven quarters. This was primarily due to a 5.5% drop in second-largest IT firm’s utilisation rate.     

What makes matters worse is that Infosys has also projected a 330 bps year-on-year (yoy) decline in operating margin in fiscal 2012. This is being seen by most analysts as a cautious outlook taken by the conservative company, which has almost always preferred to give a tempered down growth guidance.

“We view the 330 bps yoy guided FY12 margin drop more as the management’s typical cautious stance at a fiscal start, especially given the recent strength of the Indian rupee. An uptrend in realisation and better revenue growth could restrict margin drop to about 150 bps, in our view. Near term, a potential Indian rupee weakness could be the joker,” is what Standard Chartered analysts Pankaj Kapoor and Apoorva Oza wrote in their note to the investors last month on Infy’s margin guidance.

S Kris Gopalakrishnan, executive co-chairman designate of Infosys, also expects “pick-up in revenue growth” during the current fiscal to marginally prop up margin guidance.
“We have given an outlook of a drop in the margin but pick-up in growth could help the margins. We have assumed pricing to remain flat but revenue productivity is up this year,” he said.
On pricing, HSBC’s Aggarwal is taking a more bullish stance than Gopalakrishnan, which lends a rosy hue to his outlook.   

“We remain parked in the optimist camp on pricing improvement, on the back of strong correlation between pricing and local IT skill demand in the US and expected pick-up in discretionary spending. Initial anecdotal evidence and TCS’s positive guidance on pricing further strengthen our positive view,” he said.
In the fourth quarter of the last fiscal, Wipro was able to check margin tumble to just 10 bps on a quarter-on-quarter (qoq) pricing improvement of 0.9% onsite and 0.4% offshore even when its volumes dropped 1.9%.

Aggarwal also shrugs off scenario of a price war sparked off from Infy and Wipro losing market share dragging down overall pricing in the industry.

“Increasingly, we have seen investors envisaging the risk of pricing war in the sector as bellwethers such as Infosys and Wipro seem to have lost market share to HCL and TCS in 2010. We believe the risk of overall pricing going down is low considering the overall positive bias for the demand market,” he said in his report.