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IT services: Against the tide?

Mar 5, 2008

The success of the Indian IT industry over the last 10 years cannot be questioned by any means. The IT-ITES sector, which is expected to generate exports worth US$ 60 bn by 2010, will contribute US$ 115 bn to the economy from related sectors. In terms of employment creation also, the industry is expected to create about 11 m jobs over the next three years (Source: NASSCOM). That is a fantastic statistics. Now, If 2007 was bad for IT stocks (due to rupee appreciation) then 2008 is proving to be worse for the entire markets (IT stocks included). After the subprime crisis broke out in US, investors over there are reluctant to take positions even in assets, which are virtually risk-free. And the same situation is unfolding here with many fundamentally strong stocks are trading at very attractive valuations.

At this juncture, we remain positive on the leaders in the technology space - Infosys and TCS - from a 2 to 3 years perspective. However, as for the overall sector, there are some serious concerns, which can lead to further weakness in stock prices in the short to medium term.

  1. The first concern is the withdrawal of STP (software technology park) scheme, which had allowed companies located in such technology parks to avail of tax benefits like zero tax for the first five years and subsequently tax on just 50% of the annual profits. When the exemption was given in 1999, the rationale was that the software sector was in the nascent stage and required government support. However, now when the benefit is being withdrawn, the macro-economic factors (currency volatility and business concerns) are heavily tilted against companies in the sector. Also, of late, and more so after the Union Budget 2007-08 and 2008-09, it seems that the government is in no mood of extending further benefits to the software sector.

    So the only option left with IT/ITES companies is to migrate to SEZ (special economic zones) where a different set of tax benefits are provided. However, it will cause a survival problem for many small and medium size IT companies. As per laws, the minimum land space required for putting up an SEZ is 25 acres. Moreover, as per some media reports, developers are not ready to develop an SEZ if it is less than 50,000 to 100,000 square feet (sqft). Small BPO companies shall require an area of just around 3,000 to 5,000 sqft for their business operations. What will these companies do with the balance available land? This is not all. The SEZ exemption is available only if the entire unit is newly set up and simply migrating to SEZ will not entitle the company for tax benefits. Due to non-extension of the STP scheme, major capital expenditure plans of these companies have been put on hold.

  2. The second key concern is the ongoing subprime crisis in the US. However, here we are more cautious on pure play BPO players as TIER-I IT companies’ direct exposure to the subprime segment is lower than 1% of their consolidated revenues. Already the clients in the US had postponed the finalisation of their IT budgets, which earlier used to get finalised by December end. We are of the opinion that the US clients are assessing the impact of this crisis and there could be a cut in their IT spending for 2008. Or in a best-case scenario, they could spend just the amount they did in 2007. In situations like these, it is the discretionary spending that gets cut first. Although exact figures are not available for each and every company, but on an average around 30% of total revenues (all business verticals included) come from discretionary spending by clients.

  3. The third major concern is the steep increase in employee compensation over the past few years. Salaries have gone up by 15% YoY over the last three years for most of the domestic technology companies. Due to these hikes, the benefit of offshoring to the client is getting reduced over a period of time. While the companies have recently mentioned that salaries will be moderated in FY09, we believe that service providers will be better off if they an maintain a high single digit salary hikes over the next couple of years so as to maintain India’s cost edge in offshore outsourcing.

    The Union budgets 2008-09 has given a huge importance to the education sector, which will definitely help the services sector by providing a huge pool of knowledge professionals in the long run. However, investors need to take the short-term volatility in their stride if they wish to benefit from the fruits of offshoring opportunity that India shall continue to provide in the long run.

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Feb 24, 2020 (Close)