Why Nasscom’s growth number is not good for IT stocks

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Thanks to its never-ending problems, much of the news flow and the market’s attention have been centered on the banking sector of late.

Even as the banking saga was playing out, the National Association of Software & Services Companies (Nasscom) went ahead and announced its revenue target for FY18. Nasscom projections have been criticized by analysts, who say the guidance numbers pre-empt the spending budgets of companies.

Irrespective of the methodology used by Nasscom, the guidance still gives a sense of where the IT industry is headed.

According to Nasscom, the Indian IT services industry is expected to grow 7-9 percent in the next financial year. However, a revival will be seen only from the second half of next year.

Assuming the growth rate suggested by Nasscom is realistic, it still is not good enough to justify higher valuations for IT stocks.

Given the economic recovery in the US and Eurozone, the market was hopeful of a double-digit growth rate at least. To make matters worse, even the 7-9 percent growth forecast may be on the higher side.

Recent numbers and commentary from Cognizant indicate a marginally lower growth rate for 2018 than the previous year. ISG, the world’s largest third-party outsourcing deal advisor, is not hopeful of a meaningful growth for the sector this year. Nomura in a report quoting from ISG’s quarterly publication said that outlook on IT budgets remains flattish. Traditional sourcing will continue to face pricing pressure as clients look to do more with less (digitization and automation), while digital will likely make better margins for service providers.

There are other data points which suggest that traditional business will face headwinds going forward. Nomura has pointed out that deal flow momentum for top four Indian IT company has decelerated to 5 percent as compared to peak growth of 14 percent.

The only silver lining is growth in digital space. Nasscom expects digital services to grow 1.5-2 times the rest of businesses. But analysts and companies themselves expect the higher growth rate in this space.

Wipro’s chief executive officer, Abidali Neemuchwala in an interview said that in his company all expenditure is on the digital side. Nobody is investing in the legacy business. That being the case Indian IT companies still rely heavily on traditional business will grow mainly on account of their growth in the digital space.

The pace at which the sector is changing can be judged from Neemuchwala’s statement that today 25 percent of Wipro’s business is digital. He says that in three years, if 100 percent of Wipro’s business is not digital, there would be an opportunity loss.

But that is easier said than done. Going digital may require re-skilling almost all employees. Here fresh candidates may prove better as they would need to be trained and not re-trained.

The IT sector is going through a painful transition for the first time since the sector took off in the late 90s. It will be a painful journey and companies with cash reserves and patience to train their staff and wait for results will be rewarded.

For an investor, this is good news as IT companies become leaner and make more money. But at a macro level, it will affect jobs. Industry experts feel that 70 percent of IT jobs done by Indian professionals can be automated.

Wipro is already witnessing the benefit of automation where it has been able to deliver productivity equivalent to almost 12,000 FTEs (full-time employees).

However, the transition is more than just training the workforce. Order sizes in digital space are still in the USD 3-5 million range. This would mean that the industry is working from scratch in terms of bagging orders and searching for growth. This would mean that in initial years the benefit of low manpower in programming would be replaced by higher marketing cost.

Thus the benefit of digitization would take time to be visible in the bottomlines of the companies. But these would provide a good base for rapid future growth.moneycontrol