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Can Indian IT endure Wall St. crisis?

Sep 26, 2008

The financial crisis that has erupted in the US and has led to extinction of several Wall Street firms is seemingly acting as a grave concern for the Indian IT sectors. This is because US banks (both commercial and investment banks) have been among major clients for Indian IT companies. On an average, the companies derive around 60% of their export revenues from the US and a large part of the same is from the financial sector.

So, will Indian IT survive this crisis and live to tell the tale? We believe yes.

‘Comparative advantage’ will be at work
Although the companies are bound to face some short to medium term pressure on account of financial sector restructuring going on out there, the simple rule of economics – comparative advantage – will play its part in the survival and growth of Indian IT over the long term.

So what is the principle of comparative advantage?

Probably one of the most important concepts in international trade theory, ‘comparative advantage’ refers to the advantage that a country has over the other of doing an economic activity at a lower opportunity cost than the other. In simple terms and in the context of the IT industry, while the US might have the world’s best technology specialists and even those that are available in countries like India, it is in the former’s favour to outsource some functions which can be done at a lower opportunity cost in the latter (or even other countries like India).

Coming back specifically to the IT industry, it is in favour of the US corporations to keep on outsourcing their non-core technology functions to vendors who can do it more effectively. And the need for offshoring comes since the outsourced functions need to be carried out at lower costs.

Now, understand here the clear difference between ‘outsourcing’ and ‘offshoring’. ‘Outsourcing’ is simply getting work done from an external party. ‘Offshoring’ is when the outsourced function is shipped to a distant low-cost destination….like India, the Philippines, Mexico etc.

Given this understanding, it is an imperative for companies with high cost operations to outsource their non-core operations to companies with low cost operations as well as execution capabilities to complete projects on time. And Indian companies have set an example on these fronts over the past many years.

As we have heard from so many managements in the past, the need for offshoring has moved from being a pure cost-saving mechanism to now getting things done more efficiently and effectively. And this has led to corporations nowadays even offshoring some of the complex core tasks to destinations like India. Companies like GE and ABB having their R&D labs in India are cases to justify this point.

So, given all this, will Indian IT survive?
We believe that the Indian software industry has matured to live with the ongoing crisis in the US financial system. This is because the value proposition of offshoring continues to be high. While Indian IT companies might not grow at rates they have in the past, those with execution capabilities and scalability will most likely weather the ongoing crisis.

As a matter of fact, consolidation among large financial services players post the collapse, such as Bank of America’s acquisition of Merrill Lynch and Lloyd TSB’s takeover of HBOS would provide huge integration opportunities for Indian IT firms who have these companies among their major clientele.

While the crisis might impact discretionary spend on new projects in the medium term, we believe that non-discretionary spend (which is about 70% of total technology spend, as per Gartner, a technology sector research firm) by clients will continue to happen even during the downturn.

The next phase of economic recovery will focus on enhancing competitiveness, and use of technology will be critical to this phase. The India value proposition is today well established and Indian companies will look to partner with their customers as the global financial sector realigns itself.

According to Gartner, the sentiment will start to shift after December quarter and software companies may recoup some of the losses they made in the earlier quarters. The outlook for FY09 remains cautiously optimistic and that for FY10 is fairly optimistic with growth returning to earlier levels.

What to expect?
The fact that Indian IT companies are trying to increase exposure to other markets like Europe, Middle East and Asia-Pacific is likely impart some sustenance to growth going forward. Some of these companies are also trying to focus on new segment of clients (like mid-size local bank in US and Europe) and diverse verticals (such as manufacturing, retail, transport and utility) that are looking to reduce costs through offshoring.

In the long term, the export-driven software sector will become risk-protected from such uncertainties by penetrating other geographies and expanding its service offerings to diverse verticals so as to retain its competitive edge and sustain the growth momentum.

As for IT stocks, we believe that most of the sector leaders are available at very attractive valuations from a 2 to 3 years perspective (See our view). We even find value in some of the mid-size players who are largely focused on the domestic markets.

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