Tech Troubles : Structural or Cyclical?

On 5th Aug’16, Cognizant made headlines, not for its usual upbeat commentary, but for revising its guidance downwards for second straight quarter. For the first time in many years, growth is set to fall to single digit this year for this Teaneck headquartered tech giant. It is not the only one to sound caution. Not far behind, twin troubles of poor Q1 and RBS cancellation ruined the much delayed recovery prospects for both Infosys and its flamboyant head Sikka. Series of such disappointments led to analysts downgrading their forecasts in quick succession for the sector. While this underscores the challenges the Industry is facing, the key question that the long term investors are posing is whether this is a passing phase or is this more structural that will linger much longer.

To understand this, bit of history would help on how this industry evolved. The key drivers for the trail blazing growth in the last decade+ have been mainly from two major sources. Dramatic increase in traditional IT spending like ADM (Application Development & Maintenance) coupled with progressive increase in share of off-shoring fueled the growth in the sector. Off-shoring amplified the IT spending and propelled the Indian IT growth to high double digits. Both these drivers are no longer at work now. Traditional IT spending like ADM is under pressure while share of off-shoring has stabilized. With these two traditional levers leveling off, large players are left in lurch for growth. Add to this, the deflationary impact of automation, cloud and digital both on revenues and margins and increasing traction in in-sourcing (captive offshore units) , it is difficult to build a bullish structural case for the sector. As a sector, IT is past its prime and structurally the story looks weak.

Having said that, it is not all high and dry. Market share gains and investments in digital will drive growth from here-on. Companies with scale and superior execution skills will have a distinct edge in this race for more market share. As this race intensifies, the place where the damage will be severe is in the next rung i.e. tier 2 and 3 space. Players with undifferentiated offerings in this space will be at grave risk. Consolidation  of course will be the natural outcome in the mid-tier, though it is unlikely to be driven by the larger ones. It is more likely that such consolidation will be driven by PE funds. More so with PE funds owning chunk of stakes in leading companies in the 2nd tier such as Hexaware (Barings), Mphasis (Blackstone) and Zensar (Apax Partners). As market hearsay goes, NIIT Tech could be the next one on the block.

At the same time, one should be careful not to paint the entire middle with the same brush. There are companies in the second rung that are building differentiated offerings in the product space esp. in consumer banking, insurance and lending etc. These companies have stellar growth prospects and can be looked at for promising investments.

On the larger caps, though macro has much less to offer structurally, value could emerge in individual stocks if the de-rating further deepens, esp. for companies that are likely to emerge winners in the market-share gains and incrementally in digital space. Watch out for interesting stock specific opportunities.

Happy Value Investing!