Consolidation Among Tier-II IT Services Firms To Gather Pace: Crisil

CRISIL expects consolidation among Tier II IT services firms (annual revenues of Rs 1,000-10,000 crore) to gather pace over the medium term as they strive to achieve scale and build digital capabilities to stay relevant. This comes at a time when their legacy businesses – such as time and material contracts – have already become commoditized, posing significant growth and profitability challenges.

Another trend that’s also being witnessed is the exit of promoters of Tier II firms, capitalizing on higher valuations in
the past two years and better growth prospects.

Slower growth revenue

CRISIL’s analysis of the top 22 listed IT service firms shows there is a potential consolidation opportunity among
Tier II firms, which today have a combined market capitalization of Rs 33,000 crore. Pertinently, consolidation
moves worth Rs.18000 crore are already in progress among Tier II firms. Such consolidation engenders manifold synergies, boosts profitability and builds capabilities to cope up with opportunities in the digital space.

In IT services, scale begets scale as clients prefer to work with established players with proven execution
capabilities. This largely explains the slower revenue growth posted by Tier II companies in the recent past;
revenues of Tier II firms grew nearly 13% between fiscals 2013-19, a good 300 basis points slower than Tier I firms. In the previous six year period (2007-13), both Tier I and Tier II firms had grown at a 20% clip.

Digital services to drive competition

While digital services have been growing at 30% over the past three years, Tier II firms haven’t rushed to board the gravy train. Not surprisingly their share of digital revenues moved from 15% to ~22% over last 3 years as against Tier I firms, whose share galloped from 17% to 29% during the same period.

With digital requirements of clients bound to increase across business verticals, this segment will continue to drive both growth and profitability, and Tier II firms need to build competences to stay in the game.

Competition is also set to further intensify in the banking, financial services and insurance (BFSI) segment as
clients ramp up in-sourcing and go for vendor rationalization because of consolidation in global banking and rising
stringency in financial regulations. For Tier II firms, that’s a challenge because around half of their revenues come
from the BFSI segment.

“This will push Tier II firms further towards consolidation,” said Sameer Charania, Director, CRISIL Ratings. “Also, Tier II firms operate largely with a few large customers. Consolidation will, therefore, afford business complementary and cost rationalization, which will narrow their operating margin gap with Tier I firms.”

Share route for consolidation

For the record, operating margins of Tier II firms were also significantly lower at 16% over the fiscals 2013-19
against 24% for Tier I firms, reflecting the former’s lower pricing power and higher cost base.

Tier II IT firms may prefer a share swap route for consolidation given their relatively lower cash surplus (19% of
annual revenues compared with 24% for Tier I firms), though a few leveraged buyouts have also happened in the
recent past.

Traditionally IT (including Tier I and Tier II) companies have operated with very modest leverage (average debt to
EBITDA of 0.27 time in fiscal 2019), due to their healthy cash generating ability. Limited reliance on debt funding is
expected to continue, ensuring stability of credit profiles. Funding pattern on deals between Tier II firms, and benefits achieved through integration, will be monitorables.