Even though external demand has recovered from the lows of the days of the subprime crisis, not all is well at the information technology fortress. Large IT players are grappling with issues related to strategic focus while smaller ones are striving hard to grow their pie. ET Intelligence Group's Ranjit Shinde and Parul Bhatnagar outline what lies ahead for the critical players in the sector.

For the Indian information technology (IT) sector, it appears to be the best of times and the worst of times, contradictory as it may sound. The best because after the subprime crisis, the world is relying on the outsourcing capabilities of Indian IT firms like never before to transform businesses and stay competitive. And, the worst because the sector is gradually waking up to the fact that not all the top players are on an equal footing when it comes to business momentum.

Some of these firms are grappling with serious issues pertaining to either lack of strategic focus or able leadership or both. This week, ET Intelligence Group takes a closer look at the changing dynamics of the employee-driven sector to identify the ones among both the large and smaller companies which will perform well in the long run.

The juggernaut called IT
The IT-BPO sector has been one of the fastest-growing sectors in terms of revenue, exports and employment generation. Data from trade body the National Association of Software and Service Companies (Nasscom) shows that the export revenue of the sector grew at 28% in the past 10 years when compounded annually. Its share in the country?s total exports grew to over 26% from less than 10% during the period. What also makes the sector unique is the rate at which it has generated employment. Unlike most other sectors in the manufacturing industry, the IT sector has been at the forefront in terms of adding jobs. In FY11, IT companies are reckoned to have added 2.4 lakh jobs to take the total headcount to 25 lakh, according to Nasscom estimates.

Old Game, New Contenders
The sector faced a sharp slowdown due to turbulence on the macro-economy front twice in the past 10 years ? once after the dotcom bubble in early 2000 and then in 2008 when the subprime crisis hit the global economy. It, however, bounced back on both occasions. The rebound was much faster in the aftermath of the global financial crisis two-and-a-half years ago. But it is less secular this time around compared to the post dotcom era wherein most IT companies took advantage of the demand recovery. While demand has improved in the past six-eight quarters, it has not benefited top companies in equal measure. While Tata Consultancy Services, Cognizant and HCL Technologies were at the forefront of the demand uptick, traditional contenders, including Infosys and Patni, looked constrained due to their own strategies adopted in the past. Take for instance, the comparative growth rate among top three peers, including TCS, Infosys and Wipro. Infosys and Wipro grew their respective net profits at a compounded annual growth rate (CAGR) of 21-22% in the past four years. The growth was much faster at 28% for TCS. A starker picture emerges if we take into account a two-year horizon. Between FY09 and FY11, the net profit of Infosys rose by 4.5% compared with the 11% growth in Wipro?s bottomline and 18.6% in TCS?s (see graph).

The differentiators
What has separated the performance of these companies is the difference in strategies, which each one of them followed over the past five years. Infosys largely focused on margin-driven organic growth with a greater thrust on improving business efficiency. Wipro paid more attention to embedded technologies and infrastructure-related segments. TCS made investments in increasing onshore presence across Europe, Latin America and Australia. It also acquired a few companies to enhance its vertical presence. The strategy seems to have worked well because TCS could take advantage of the revival in outsourcing demand over the past six quarters. It commanded the biggest share of the incremental revenue and operating profit during the period. The company also pruned its operating cost structure to improve profitability of its business. HCL Tech, on the other hand, improved its revenue growth largely at the expense of margins and earnings growth. It was more aggressive on the inorganic front and even beat Infosys in a race to acquire UK-based enterprise solutions provider, Axon, in 2008. Its profitability remained the lowest among its larger peers during the past two years. The picture is, however, changing gradually since its investments have started paying off.

The new IT order
As it appears now, TCS, Cognizant and HCL Tech are likely to expand their share of outsourcing pie largely at the expense of Infosys and Wipro. Taking cues from the recent past, the latter two have undertaken organisation-wide changes. Both of them have recently restructured their top decks. Wipro has shifted back to a one-CEO strategy after trying out the two-CEO structure. Infosys, in contrast, has adopted a two-chairmen strategy, which will lead a battery of senior executives. These structural changes in Infosys and Wipro will take at least a few quarters before it is reflected in any material change in their performance. Until then, industry trackers feel that the duo will tend to show a lacklustre growth compared to their peers.

The road ahead
After a sharp turnaround in the past few quarters, IT demand is likely to show some fatigue given higher-than-expected time taken for recovery by Western economies, which contribute more than two-thirds to India?s IT exports. The uncertainty in economic parameters may increase the decision-making time when it comes to allocating budget for new projects. It could also restrict the increase in billing rates, which have more or less remained sluggish in the past two years. If demand tends to lag behind the expectations of IT players, it could impact employee utilisation significantly since most top firms have continued to add workforce. This would eventually pull margins down. While the scope for smaller IT firms would remain limited, a few companies which invested right during the slowdown could well be in a position to grow at a faster clip. Companies such as Hexaware, Subex, Persistent and KPIT Cummins have reported impressive growth in the past few quarters. ET Intelligence Group provides a snapshot on some of the large and small companies with an emphasis on what to expect from them in the coming quarters.

TCS (Hold)
For the two years ended March 2009, the performance of TCS was under pressure due to heavy losses on account of foreign currency hedging. The company?s substantial hedging position was adversely impacted because of rupee depreciation during the period. The company entered FY11 clear of these loss-making hedges, which supported its overall business growth. The company has also pruned costs over the past few quarters, which have catapulted its operating margin to 28% from 23% two years ago. The company has reported sustained momentum in large multi-year contracts. It has aggressive plans to add employees in FY12, which reflects its strong demand expectations. Its stock trades at a P/E of 25.8 based on trailing 12 months earnings. Its net profit is expected to grow by over 20% in FY12 on top of 26% growth in the previous year, which makes its forward P/E to be 21.5. The stock has risen sharply in the past few months reflecting its future growth expectations. Hence, a further increase looks limited but long-erm investors may continue to hold the stock given the company?s strong market position.