Tariff uncertainty and rising localization costs could further squeeze IT margins: Sandip Agarwal
ETMarkets.com
I am fearing that if no deal cancellation happens in next three-four months, then the journey will be much more smoother.
"Even during Lehman Crisis also that revenue was always there. It cannot change. Even in covid that was there. So, in worst case scenario your revenue can only decline by 5-6% because 80% of the total revenue is very sticky," says Sandip Agarwal, Sowilo Investment Managers.
You heard the management commentary coming in from Infosys. Overall, the commentary on the sector has been rather cautious. So, what is the overall pulse that you are catching of the sector?
Sandip Agarwal: I have run a tech company and it is almost two decades I have been tracking tech now. So, in technology what happens is 80-90% of the spend which is there from the client is actually the top priority spend, that means that you cannot negotiate that spend in any case because that runs your day-to-day systems, your maintenance your annuity, so it is very-very sticky annuity business, it never comes under risk. Even during Lehman Crisis also that revenue was always there. It cannot change. Even in covid that was there. So, in worst case scenario your revenue can only decline by 5-6% because 80% of the total revenue is very sticky. The challenge is that the balanced 20% is the last priority. So, in IT you have first priority 80% of the business which can be touched and then there is 20% such business which is completely discretionary in nature and which is last priority. Now always the challenge comes in this 20% because this 20% whenever there is a little bit of uncertainty also this gets postponed, delayed, cancellation, everything happens in this 20%. So, my view is that and this is what we were saying from last eight-nine months that the index has done extremely well, it has moved up substantially and now the valuations are unsustainable and being a presidency change we have always seen when presidency changes happen in US, we see some trouble for it because it is a very big business for us, it is a big foreign exchange earner. So, there is always some kind of increase in cost. If you remember in 2014, we saw the increase in localisation which has killed the margin of the sector by 5-6% in last 10 years.
So, the challenge is this. So, this time also what happens in case of tariff, you know there is a problem with the country, there will be some negotiation, some solution but when there is uncertainty on global growth where your 90% business is coming from outside India, you cannot grow till there is uncertainty. So, that is our challenge. It is a very different kind of sector where some portion is secured forever and very small portion is unsecured and that always gets hit hard in uncertain times.
In fact, there has been some weakness over the past many months and that is due to inflationary concerns. There have been concerns regarding elevated interest rates as well. However, how concerning could this get given that now there are concerns around a possible recession?
Sandip Agarwal: So, there are two-three things. One, if there is a recession, obviously we have seen in past that US going into recession has hit all the economies across the globe. The impact can come with a lag effect.
And as I mentioned that while on paper it may look that different IT companies have different kind of exposure to the US, maybe somewhere someone has 40, someone has 60, someone has 50, but the balance 25-30% which is coming from Europe and other developed market, also most portion of that is from the branches or the subsidiaries of those companies which are from US. So, basically the whole export is directly-indirectly related to US. So, if there is a recession and that recession has its definition. So, if it is a mild, soft landing kind of recession, then the revenues will be secured, you may degrow at most 2-3% and you can grow at most 2-3%, I think that is the situation today. If there is a very-very tough, hard landing like we saw in covid or post Lehman Crisis, then one or two quarter you can see a sharper degrowth, maybe 5-7-10%, but then that is short lived because when you go into degrowth, then that portion of the revenue is also quite important and that comes back first. So, what does not come is the revenue which is above 100%. So, whatever you did last year is more or less secured, but anything above that environment has to be stable at least if not good.
So, on the back of that, what would be your forecast for 2025-26 in comparison to last year for the sector?
Sandip Agarwal: So, this year it will be a tough year. I do not see more than 3-4% growth for the industry and I will tell you the reason because see, our IT industry by nature is a first half driven industry, except if you leave some of the companies which have higher exposure to domestic, like Wipro has more exposure to domestic and Middle East. So, if you leave that aside, we are a first half country, in terms of most of the companies achieve their most part of their growth in the first half because if you recall quarter three is a Christmas holiday and manufacturing furlough quarter and then March is a less number of working days in February which eats away almost like even if you assume two days it takes away your 2-2.5% of revenue. So, we are a first half-driven company and going by the situation we are right now I think this first half of this year is gone and if the first half of this year is gone, then second half no way you can grow more than 2-3% for the full year. It will also be a daunting task. So, I think that is what I am making out of the current situation. It will be very hard to show higher growth than previous year in this year for anyone it will has to be a miracle. Even if it happens, it will be like low-single digit kind of growth.
So, is there going to be any silver lining to all of this or is the downturn fairly broad-based?
Sandip Agarwal: I think downturn is broad based but prima facie the situation which is there today, the worst hit will be maybe manufacturing because the highest amount of uncertainty is in the manufacturing space and I see serious challenges there and particularly what we are hearing is that ERP is completely right now is in a very dull mode. There is no demand in that space. So, again, that is mostly to do with the manufacturing side of it.
When you say that amongst all of these segments manufacturing you are starting that that is going to be the worst hit, but how do you see companies manoeuvring to these challenges and there are quite a lot of them. What is the current thinking that you are hearing from companies and what are we going to see more of in the IT industry in terms of trends for instance, will there be more deal pauses, what are you going to see on the deal conversion front, on decision making front?
Sandip Agarwal: So, right now, my biggest fear is that in next one month or two month you will see some deal cancellations and the big size ones and that is the worst thing to happen because any deal cancellation, the challenge which happens is that it completely stops all other clients from giving any discretionary deals and I am honest, if you see last 20 years every time when this kind of situation on US or global economy has happened, we have seen that in coming months one or two months there has been some deal cancellation. Now, that deal cancellation may be a small deal of $100 million which is nothing for our size of exports and our size of revenues, but problem is that clients start thinking that better to wait for six more months and get full clarity before we are awarding a deal today and then cancelling that is the challenge. So, as I said postponements, delays, and cancellation these are the three very-very bad outcomes of this kind of situation which I am fearing. I am fearing that if no deal cancellation happens in next three-four months, then the journey will be much more smoother.
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