Continued adaptability will be key to success for Indian IT services companies

In November, martinwolf president Marty Wolf published a column in VCCircle addressing the greatest threat faced by India's IT firms. Surprisingly, that challenge was not the fast-growing Chinese IT services industry — but instead the ongoing shift in the types of services that large enterprise customers in North America and Europe are buying.

In an increasingly crowded global market, Indian IT services companies have long been able to distinguish themselves from their competitors. Although cost remains an arbitrage opportunity, Indian IT services companies are equally strong on capabilities with other global players baring gaps in industry domain expertise—which can be key in building higher margin consulting type organisations.

When our firm analysed this in November, however, we found that this has not been a "rising tide floats all boats" scenario. India's Tier 1 IT firms (those with annual revenue greater than $1 billion) saw their market capitalisation rise 30% since November 2012, while Tier 2 companies (those with annual revenue between $500 million and $1 billion) saw a 4% increase over the same period. The result of this (and similar trends in previous years) has been a significant valuation difference between Tier 1 and Tier 2 IT services companies, which will continue to be in same range for the foreseeable future.

What's new since November

As of today, both Tier 1 and Tier 2 valuations are growing—though Tier 1 valuations remain significantly higher than their Tier 2 counterparts. Since November 2013, however, Tier 2 firms have been growing slightly faster on both a revenue multiple and EBITDA multiple basis—as is expected from their greater susceptibility to market forces. On a revenue multiple basis, Tier 1 valuations have gone up from a 3.7xto 4x (a 6.7% increase) while Tier 2 valuations have grown from 0.9x to 1.1x (a 23% increase).For EBITDA, the numbers are similar—15.1x to 15.9x for Tier 1 vs. 6.5x to 8.4x (increases of5.5% and 29.5% increase, respectively).

There are many reasons for this uptick in valuations. chief among them is an increased confidence in and demand for the IT services industry. Major US indexes closed 2013 with substantial increases, testifying to an increasingly healthy economy and with it a redoubled need for global IT services solutions, especially in markets that constitute a majority of Indian IT services providers' clients. Thanks to India's comparative advantages as the dominant offshore IT services provider, its companies were best able to capitalize on this growing demand.

But a significant factor in this shift is perhaps an unlikely source: the rupee (INR). The Indian rupee has depreciated over 12% against the USD over the past 12 month, causing an immediate negative effect in April 2013 on the EV of Indian IT services companies due to the devaluation of financial statements tracked in INR.

However, this negative effect quickly subsided. In August 2013, when the rupee was at its lowest point relative to the dollar, enterprise values began to increase and have continued to do so through the present day. Though initially this trend reversal may seem counterintuitive, it is actually highly rational: with devalued financial statements, Indian companies have a higher future earnings growth potential and are more competitive in the global marketplace.

Smaller companies, being more exposed to fluctuations in domestic exchanges rates, have benefitted to a greater extent in terms of market cap—explaining the relatively higher valuation growth for Tier II companies.

Looking forward into 2014 and beyond

As we conclude the first quarter of 2014, we believe that B2B cloud services—expected to amass more than $180 billion in global end-user spending by 2015—will continue to be a differentiator in the short term, helping to generate new business. But ultimately it will have little topline impact on major Indian IT services companies, which we instead expect to see increased demand in the form of traditional app outsourcing and IMS. Other newer technologies including analytics and mobile will be of interest, but their comparatively higher valuations will keep buyers away at least for one more year.

The major M&A theme for the coming year will instead be a continued convergence in the IT services field as both Tier 1 and Tier 2 companies look to expand to differentiate themselves from their competitors and grow their top lines.  We also anticipate sub $100M IT services deals focusing on Oracle or SAP to serve both topline improvement and capability expansion—especially from Tier 2 players.

We have seen increased interest in expanding IT BPO capabilities, even from traditional IT outsourcing giants, as well as a growing demand for captives that could quickly provide large accounts for the acquirer. Similarly, traditional BPO companies are looking to build out their services offerings. In the Tier 2 space, there is additional trend of Indian companies going private—as we saw with Hexaware—which will allow more growth through acquisition and margin management during the growth phase.

While Chinese IT services companies still lag behind their Indian peers, they are increasingly aggressive in their race to catch up. Chinese IT services companies have had nearly twice the number of transactions, often at a larger size, as their Indian counterparts. In order to remain ahead, Indian companies will need to be more active in the M&A space to ensure they can cater to all aspects of customer demand.

The challenges that we identified in November still loom large on the horizon—Tier 2 Indian companies fight hard for significantly smaller valuations than their Tier I peers and an increasingly crowded global market puts pressure on all IT services providers to offer the services demanded by their customers.  But the qualities that make India the market leader—and the experience of managing margins from their decades of being that leader—will enable Indian IT services providers to stay ahead if they are able to adapt to the always-evolving IT services environment.

(Gaurav Sharma is senior vice president and managing director of martinwolf's India Practice.)

To become a guest contributor with VCCircle, write to shrija@vccircle.com.