Growth challenges to force consolidation among tier two IT firms, says CRISIL study

Growth challenges to force consolidation among tier two IT firms, says CRISIL study
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3 Jul, 2019

Credit rating agency CRISIL (formerly Credit Information Services of India Ltd) said that growth challenges will force tier two information technology (IT) services firms to look at consolidation over the medium term.

The companies are facing multiple headwinds related to onsite hiring and margins even as they work towards achieving scale and build emerging technology capabilities in order to stay relevant.

CRISIL, owned by credit rating agency Standard & Poor’s, said that the consolidation will come at a time when the IT firms’ legacy businesses (such as time and material contracts) have become commoditised, thereby prompting challenges on the fronts of growth and profitability.

Competition is also set to further intensify in the banking, financial services and insurance (BFSI) segment as clients ramp up insourcing and go for vendor rationalisation because of consolidation in global banking and rising stringency in financial regulations, CRISIL said. For tier two firms, around half of their revenues come from the BFSI segment, it added.

“This will push tier two firms further towards consolidation. Tier two firms operate largely with a few large customers. Consolidation will, therefore, afford business complementarity and cost rationalisation, which will narrow their operating margin gap with tier one firms,” said Sameer Charania, director, ratings, CRISIL.

CRISIL's analysis of the top 22 listed IT service firms shows there is a consolidation opportunity among tier two firms, which today have a combined market capitalisation of Rs 33,000 crore. Pertinently, consolidation moves worth Rs 18,000 crore are already in progress among tier two firms.

"Such consolidation engenders manifold synergies, boosts profitability and builds capabilities to cope up with opportunities in the digital space," Charania added.

While digital services have been growing at 30% over the past three years, tier two firms haven’t rushed to board the gravy train, the study said. Not surprisingly, their share of digital revenues moved from 15% to 22% over the last three years as against tier one firms, whose share galloped from 17% to 29% during the same period, CRISIL added.

CRISIL said that it saw another trend— the exit of promoters of tier two firms capitalising on higher valuations in the past two years and better growth prospects.

In May, CRISIL had said that margins of IT firms will shrink up to 80 basis points (0.8%) for financial year 2019-20. 

Early last month, a Kotak Institutional Equities’ analysis of earnings calls by European and US companies found that overall technology investments are expected to be lower than last year

Findings by ratings agency ICRA suggested that digital technologies will drive the IT sector in India as outsourcing continues to face pricing pressures. It said that while demand for IT services will remain stable, visa issues and on-site recruitment will constrain profitability. 

As Indian IT services firms continue to grapple with tougher visa regulations under the Trump administration, they are setting up more centres and offices in the US, such as Tech Mahindra, which opened its new centre in Missouri last month

In April, there was hope for optimism as software services giant Accenture forecast an increase in its revenue growth for financial year 2019-20 at a time when the Indian IT industry was limping back from a period of sluggish growth.