CRISIL expects the share of digital services¹ in Indian’s information technology (IT) exports to double to ~30% by fiscal 2020, as the segment grows at a healthy 30-35% a year. This will be supported by re-skilling of employees and increased mergers & acquisitions (M&As) by Indian IT players, seeking to enhance the digital pie in revenues.

On the other hand, the share of traditional IT services, which account for the bulk of the $140 billion-a-year Indian IT industry, will decline given the flaccid 2-4% annual growth currently. Overall IT revenue growth is expected at ~8% per annum until fiscal 2020, driven largely by digital services.

Revenue growth in the industry slowed to below 10% between fiscals 2015 and 2017, from a very strong 27% compound annual growth rate seen in two decades through fiscal 2014. With bulk of the revenue coming from exports of services, lower IT spend by major global clients and a shift in demand towards digital services have led to the decline.

The share of digital services revenue in India’s IT exports is low at ~15% now, given the late entry by domestic firms. But this business grew more than 25% in fiscal 2017 as domestic firms won digital deals, backed by re-skilling of employees. This trend is set to accelerate.

“The share of digital services in new global outsourcing contracts is estimated to have doubled to ~40% in fiscal 2017 from three years back, and will drive revenue growth going forward,” said Anuj Sethi, Senior Director, CRISIL Ratings. “For major IT players based outside India, more than a third of revenue already comes from digital services.”

Besides in-house digital skill building, IT firms are likely to undertake more acquisitions that will accelerate revenue growth from digital services. Not surprisingly, M&As in the Indian IT digital space surged to 64 in fiscal 2017 from 39 in 2014. One in every three IT acquisitions was in this space, as per NASSCOM.

“We foresee an increase in moderate-sized acquisitions in the digital space by both Tier I² and Tier II firms to expand digital offerings and build scale,” said Rajeswari Karthigeyan, Associate Director, CRISIL Ratings. “For Tier II firms, acquisition activity will also be driven by the need to diversify existing offerings - an area of strength for Tier I firms already.”

CRISIL rates over 70 IT firms. Slowing growth of traditional IT services, exchange rate volatility, and rising employee costs are exacerbating profitability pressures in the sector.

The credit profiles of Tier I and II firms are nevertheless expected to remain stable over the medium term – as they have in the past three fiscals – supported by strong balance sheets.

Tier III firms, on the other hand, have lower margins and relatively leveraged financial profiles compared with Tier I and II firms. The credit ratio (upgrades to downgrades) of CRISIL-rated Tier III firms was lower than 1 in two of last three fiscals. CRISIL believes the credit quality of Tier III firms, especially those unable to adapt to changing business environment, will remain vulnerable.