Sector Update | 21 June 2019
| Fuelled To Fly
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The trend of gradually receding gross margins
Profitability a key near- term risk; Watch out for 1Q performance
The trend of declining gross margins in IT Services…:
Aggregate gross margins
of Tier-I IT companies plunged by 370bp to 37.7% during FY14-19 from earlier
41.5%. Within Tier-II, aggregate gross margins declined by ~290bp, but the dip
was not as uniform as seen in Tier-I companies due to bottom-up company-
specific factors. TCS and INFY both contributed to the downward trend. While
employee costs played truant in the case of TCS, sub-contractor expenses hurt
INFY. Further, investments in Digital capabilities and pressure in traditional
contracts too played a part in the declining gross margin trend.
…while the margin levers have played their part:
The INR’s 15% depreciation
v/s the USD would have been offset by up to 40-50% by cross currency
movements. But even adjusting for that, it would leave the companies with
~250bp of positive margin impact theoretically. TCS has often cited that the
currency depreciation is incidental to the prevailing cost inflation of wages in
India. And hence, that fact as a natural offset to the wage escalation should be
inherently embedded in the model. Utilization rates too have increased across
the board, visible in the few companies that continue to report the metric. The
uptick in utilization is understandable, with feasibility for the same facilitated by
declining growth rates over this period, which did away with the need for high
bench strength seen in earlier years.
Downward risk to estimates for companies such as INFY, TCS?:
currency stability, rising attrition rates across the industry and on-going supply
crunch coupled with high visa rejection rates pose a threat to margin estimates
is faced with headwinds from wage hikes, visa costs and also remnant
investments in localization, which collectively add up to 150-200bp. A soft
start at ~20% EBIT levels would imply full-year average near the lower end
of 21-23% margin band. Currently, 1QFY20 estimate stands at 20.8% and
FY20 consensus estimate is 22.2%.
has cited that wage hikes are ~200bp headwind to margins (180bp in
1QFY19). In the absence of significant pull-back from some levers, it may
start the year close to ~24% (v/s 1QFY20 estimate of 24.4% and FY20
estimate of 25.5%).
contraction of the margin band for FY20 was a key negative surprise.
Multiple TIER-II IT companies have cited that the going w.r.t the supply
dynamics has been toughening in recent quarters.
CYL and ZENT are expecting to buck the trend.
non-core business has been a material drag on its margins in the past.
The company is looking to exit this segment, a step which should aid margins. In
addition, there are levers (sub-contractors, Digital) to expand core margins by
– Research analyst
(Ashish.Chopra@MotilalOswal.com); +91 22 6129 1530
Research Analyst: Anmol Garg
(Anmol.Garg@MotilalOswal.com); +91 22 7193 4271 /
Investors are advised to refer through important disclosures made at the last page of the Research Report.
Motilal Oswal research is available on www.motilaloswal.com/Institutional-Equities, Bloomberg, Thomson Reuters, Factset and S&P Capital.