Outsourcing: Well Programmed to Tackle Uncertainty

Since Indian information technology (IT) companies face increasing risks due to the weakening economies in the US and Europe, which could hurt IT spending. Hence Standard & Poors ratings services recently revised its base-case outlook for the US high-tech sector for 2011 and 2012 from slightly positive to neutral to slightly negative. Increasing protectionist policies, foreign exchange fluctuations, and high wage inflation in India are also weighing on these companies.

Nevertheless, we expect the top 3 Indian IT companiesTata Consultancy Services (TCS; BBB+/Stable/--), Infosys (BBB+/Stable/--), and Wipro (BBB/Positive/--)to maintain their investment-grade ratings. These companies account for nearly 25% of the $76 bn total revenues for the Indian IT software and services industry.

Indian IT companies have time-proven, mature delivery processes, a cost-competitive employee base, and an increasing breadth of service offeringsfactors that enable them to compete with global players, which have wider technology and service capabilities. For these reasons, we expect them to maintain industry-leading EBITDA margins and log double-digit growth in the next 12 months, while upholding their satisfactory business risk profiles and modest financial risk profiles. However we believe the industrys expectations of faster revenue growth in the fiscal years ending March 2012 and 2013, following healthy growth in fiscal 2011, may not materialize.

The Major Hurdles for the Indian IT Companies

• n High Dependence on Slowing US and European Economies: A slowdown in demand from the US and Europe could hurt growth of the Indian IT companies, which get more than 80% of their revenues from these countries. Recently, Standard & Poors lowered its forecast for US GDP growth for 2011 from 2.6% to 1.6%. Also, we have reduced our 2012 GDP growth forecast for the Eurozone from 1.5% to 1.1%. Fiscal tightening measures in the US and many countries across Europe could hurt business sentiment, leading to lower private sector spending on IT services in 2012
  and 2013.



• Staggering Economy: Pessimistic business sentiment is likely to cause actual IT spending in 2011 to be lower than budgeted at the start of the year. We expect budgets in 2012 to be relatively flat. Moreover the large deals that the big 3 Indian IT companies target may get staggered over time. Though deal cancellations are not as significant as they were in 2008-09, the time it takes to close deals has lengthened.
• Protectionism and Vigilance Risks: High unemployment rates, slowing growth, and political activism in many countries are generating opposition to outsourcing. Moreover some Indian IT companies are facing lawsuits for visa violations, leading to a closer scrutiny of visa applications. In our view, the biggest risk to these companies is the loss of reputation if the fraud allegations prove true, which could lead to a loss of business and hamper growth. These trends could hurt the Indian IT companies, which derive 45-50% of revenues from on-site services and depend on the Indian employees to execute contracts.
• Volatile Foreign Exchange Rates: We expect volatility in foreign exchange rates to continue due to global economic uncertainties. Indian IT companies have benefited from the strengthening of the US dollar against the rupee in the past couple of quarters, and any reversal will dent margins. These companies estimate that a 1% rise in the value of the rupee against the dollar would cause a 40-60 bps drop in EBITDA margin.

Prepared to Face the Difficulties

We believe the big 3 Indian IT companies (and global multinational corporations with a large base in India) will continue to grow at a faster pace than the global industry, at least over the next few years. This is because of their cost competitiveness and proven delivery capability, which help them stay competitive even amid macroeconomic uncertainties.

Industry-leading EBITDA Margins: Reflect Active Employee Management

Since the slowdown in 2008, the top 3 Indian IT companies have demonstrated remarkable flexibility, allowing them to maintain industry-leading EBITDA margins despite high wage inflation. The margins of the big 3 Indian IT companies are 1.5x-2.0x that of many US and European peers. This provides them a greater flexibility to compete amid declining demand. Indian IT companies have maintained employee costs at about 50% of revenues through a change in their hiring mix and better employee utilization.

Factors that Support Outsourcing in India

• Cost Cutting: We expect demand for outsourcing to India to continue as organizations focus on cutting costs in a slowing global economy. According to Nasscom estimates, companies outsourcing work to India save as much as 30-50% in costs. Companies also have limited flexibility to defer spending to meet regulatory requirements.



• Strategic Acquisitions: Although Indian IT companies have large cash balances and liquid assets, these companies have historically been conservative about acquisitions. We believe certain targeted acquisitions could improve the business risk profiles of the Indian IT companies if the businesses: improve diversity, help expand into new technologies, increase focus on areas less vulnerable to economic cycles, or increase value added services. Deploying surplus cash outside of India could reduce Indian IT companies exposure to the Indian sovereign risk.
• Investment-grade Ratings Should Remain Intact: We believe the big 3 Indian IT companies will be able to weather uncertain and volatile demand due to their cost-competitive delivery capabilities. The bigger challenges for these companies in the longer term arethe potential for a decline in their cost advantage, a rise in protectionist sentiment, reputation risk from visa violation allegations, and emerging disruptive technologies. In the past, the big 3 Indian IT companies have been flexible in meeting similar challenges, and we expect them to continue to adapt.