Infosys’s lower profitability warning of a new normal?

Bengaluru: Infosys Ltd lowering its profitability outlook for the current financial year is a sign of worry for all companies, according to analysts and industry executives, who say that the core services business is falling apart even as companies struggle to earn more from offering newer solutions.

Despite a favourable rupee-dollar movement and companies adding fewer employees, India’s three largest information technology (IT) firms, including Infosys Ltd, Tata Consultancy Services Ltd and Wipro Ltd, have seen their profitability decline in the past five years.

Worryingly for investors, many believe that both TCS and Wipro could lower their profitability outlook for the current financial year.

TCS declares its earnings on 19 April, while Wipro reports its fourth-quarter and full-year earnings on 25 April.

“…(W)e do not think FY19 is a one-time event and represents a new normal,” Keith Bachman, an analyst with BMO Capital Markets, wrote in a note dated 11 April. “Our read through is that margins will likely be under pressure for the IT services sector broadly, and is also evidenced by ACN’s (Accenture) margin performance/guidance in the February quarter.”

On Friday, Infosys, while declaring lukewarm full-year results, lowered its profitability outlook to 22-24% for 2018-19, as against 24-26% two years back.

Last month, Accenture Plc, while declaring its second-quarter earnings, reported an operating margin of 13.4%, narrowing 30 basis points from the year-ago period.

Three reasons explain this continued pressure on profitability.

Firstly, all IT outsourcing firms have seen an increase in wage bill on account of hiring locals in overseas markets, including the US and Europe.

Secondly, companies increasing the pace of acquiring companies focused on newer technologies means their overall profitability will remain challenged. A case in point is Wipro, which saw its operating margin fall by over 200 basis points after the company spent over $1 billion in buying five companies between April 2016 and December 2017.

Finally, intense pricing pressure on commoditized deals, which still account for over three-fourths of total revenues at these companies, is another reason. Digital, the fuzzy umbrella term, which each company uses to call revenue generated from areas generally classified as social, mobile, analytics, cloud computing and Internet of Things, still brings less than one-fourth of overall business.

“It is an absolutely cut-throat environment out there… Despite all companies offering digital technologies, the fact remains that 75-80% of business is still traditional work. All rebids are seeing up to 20% discounts being offered by IT vendors. So, even if you add digital on top of this, traditional or overall business is hardly growing and so profitability will remain under pressure,” said an Wipro executive on the condition of anonymity.

Still, executives at IT firms say that it will be foolhardy to write off the sector.

“There are not many industries that can claim of having 22-23% profitability. So why should IT outsourcing be an exception? But for sure, a new normal is being scripted when most companies will see at least a 200-300 basis points decline in profitability in the next two-three years,” said an executive at TCS.

Infosys’s operating margin dropped to 24.7% at the end of March 2018 as against 26.3% at the end of March 2013.

This despite a 18% favourable movement in currency (INR/USD was 54.54 for the year ended March 2013 as against 64.46 in the year ended March 2018.

“We believe INFY (Infosys) will have a very difficult time growing its operating margins over the next few years, given increased onsite mix from digital penetration as well as limited incremental utilization expansion. We are forecasting FY2018 margins of 23.2%,” BMO analyst Bachman wrote in his note.livemint

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