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Industry Risk Score

CENTURION BANK OF PUNJAB January 2008

IT Services

Introduction
Industry Risk Score (IRS) reflects the impact of industry variables on the cash flows and debt repayment ability of the companies in the industry over a 3-4 year period. The risk score for an industry is arrived at by aggregating the scores assigned to the relevant parameters for the industry. Industry parameters include variables such as demandsupply outlook, cost structures, competition and financial performance. Parameters are selected based on the extent to which they affect the debt servicing ability of the companies operating in the industry. Scores on these parameters reflect the extent of positive/negative impact on cash flows, and the degree of variability in cash flows of the companies. The industry risk scores have been graded on a ten-point scale, with 1 indicating high risk and 10 indicating low risk.
Risk score 1 2 3 4 5 6 7 8 9 10 Risk factors Extremely negative Extremely negative Negative Marginally negative Neutral Marginally positive Positive Positive Highly positive Highly positive

Contents
Executive summary Background Industry risk parameters Demand-supply Government policies Input-related risk Extent of competition Financial risk Annexure 1 2 3 3 3 4 4 5 6

Industry Risk Scores Industry Risk Scores (available on 135 industries) capture the influence of industry variables and the extent of positive/negative impact on the cash flows and debt repayment ability of companies in an industry over a 3-4 year horizon. The risk score for an industry is arrived at by aggregating the scores assigned to the relevant parameters like demand supply outlook, cost structures, competition and financial performance.

About CRISIL Limited CRISIL is India's leading Ratings, Research, Risk and Policy Advisory Company. CRISIL offers domestic and international customers a unique combination of local insights and global perspectives, delivering independent information, opinions and solutions that help them make better informed business and investment decisions, improve the efficiency of markets and market participants, and help shape infrastructure policy and projects. Its integrated range of capabilities includes credit ratings and risk assessment; research on India's economy, industries and companies; global equity research; fund services; risk management and infrastructure advisory services. About CRISIL Research CRISIL Research is India's largest independent, integrated research house. We leverage our unique, integrated research platform and capabilities spanning the entire economy-industry-company spectrum to deliver superior perspectives and insights to over 600 domestic and global clients, through a range of subscription products and customised solutions.

Disclaimer CRISIL Research, a Division of CRISIL Limited has taken due care and caution in preparing this Report. Information has been obtained by CRISIL from sources which it considers reliable. However, CRISIL does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. CRISIL is not liable for investment decisions which may be based on the views expressed in this Report. CRISIL especially states that it has no financial liability whatsoever to the subscribers/ users/ transmitters/ distributors of this Report. CRISIL Research operates independently of, and does not have access to information obtained by CRISILs Ratings Division, which may, in its regular operations, obtain information of a confidential nature which is not available to CRISIL Research. No part of this Report may be published/reproduced in any form without CRISILs prior written approval.

Executive summary
Industry Although the Indian IT services industry has strong growth potential, margins continue to remain under pressure due to rising employee costs. Within the Indian IT industry, strategies followed by large players (comprising TCS, Infoys, Wipro, Satyam and HCL Tech) and relatively small players are clearly distinct. While large players are focusing on moving to higher-end service lines, recruiting manpower with domainspecific expertise and positioning themselves as end-to-end solution providers, most small players are focusing on niche verticals and geographies to avoid head-on competition with the top tier. At the middle management level, the rising employee cost in the industry is most severe. Individuals with domain-specific experience face intensified competition. Escalating attrition rates are also causing employee costs to move northward.
Parameter IT- Services : Industry risk score Industry characteristics Demand-supply gap Government policy Input-related risk Extent of competition Industry financials Operating margin of industry RoCE of industry Source: CRISIL Research 85 30 10 30 30 15 35 65 Weightage Score 7.5 7.1 9.0 8.0 6.0 6.0 9.5 8.7 10.0

CRISIL RESEARCH IT- SERVICES

JANUARY 2008

Background
The Indian IT industry is categorised into IT services, IT-enabled services (ITeS), software products and hardware. In the Indian context, the term software is associated with software products and IT services. However, the bulk of revenues is derived from IT services, with some select companies having a marginal presence in software products. The software industry, including software products, IT services and engineering and R&D services, is one of the fastest-growing sectors in the Indian economy. Over the last 5 years, this industry grew at a CAGR of 23.7 per cent to reach $22.3 billion in 2005-06. Exports have been growing at a faster rate than domestic revenues. While exports have grown at a CAGR of 26.4 per cent over the last 5 years and touched $17.1 billion in March 2006, domestic revenues grew at 17.0 per cent and reached $5.2 billion during the same period. The industry mainly depends on the North American market, especially the US, for revenues. India also exports to other countries in Europe and Asia-Pacific. Although the share of Europe has been increasing consistently, the US continued to remain the largest client, accounting for 67 per cent of the Indian IT industry`s export revenues in 2005-06.

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CRISIL RESEARCH IT- SERVICES:

Industry risk parameters


Demand-supply High growth rates witnessed by the Indian IT industry have moderated to those in the mid-twenties, primarily because of the rupee appreciation and wage inflation last year. The 13 per cent rupee appreciation vis--vis the US dollar over the past year has exerted huge pressure on margins of Indian players. Double-digit wage inflation has only added to the woes of Indian players. The Indian IT industry is expected to carry forward the growth rate of mid-twenties, thanks to its low share in the global offshore market. The entry of Indian players into more profitable service lines and new verticals is expected to add to their bottomlines. According to CRISIL Research estimates, Indian IT service industry`s export revenue will touch $39.4 billion in 2010-11, growing at a CAGR of 24.3 per cent during 2006-11. The Indian software industry is heavily dependent on exports. As a result, its growth rates are linked to changes in global macro-economic indicators and their effects on worldwide IT spending. According to IDC, global spending on IT services is estimated to have touched $470 billion in 2006. It is expected to grow at a CAGR of 5.6 per cent over the next 5 years. With its unique offshore delivery model and low-cost high-quality proposition, the Indian IT services industry is slated to benefit from the growth in global IT spending. With an increasing presence of global IT companies in India, the acceptability of the offshore model has improved significantly. Industry billing rates have remained stable. We expect billing rates to remain at present levels in the short term, and improve in the medium term as companies shift to higher-end service lines. Government policies Given the export potential and employment generating opportunities in the industry, the government`s domestic policies have been encouraging. Some of the key positives for IT companies from a policy perspective are as follows: Profits of companies that are located in or registered under software technology parks are exempted under Section 10A of the Income Tax Act for 10 years from the commencement of operations, or up to 2009-10, whichever is earlier. The software industry has been permitted duty-free imports of various capital goods. One hundred per cent foreign investments are permitted in the sector through the automatic approval route. Besides, to facilitate global acquisitions by Indian companies, Union Budget 2003-04 increased the investment limit for overseas acquisitions to 100 per cent of their net worth. These acquisitions would not require prior approval and could also be undertaken through the issue of ADRs/GDRs.

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In Union Budget 2007-08, a minimum alternate tax has been imposed on the domestic IT/ITeS industry. However, its impact on the credit profile of the software industry would be limited due to the higher margin cushion. Input-related risk Industry margins compare favourably with other industries, despite the higher middle level employee costs and high attrition levels. The most critical input for the software industry is human resources. According to the estimates of National Association of Software and Service Companies (Nasscom), the Indian IT exports sector, excluding hardware and ITeS, employed around 690,000 professionals in 2006-07. Most of this demand is met through engineering graduates, with graduates from other streams and professionals from non-software disciplines accounting for the balance. To meet the future increase in export demand, the sector will require a large number of engineering graduates. As labour cost arbitrage is the main driver of offshore outsourcing of IT services, India is the preferred destination, thanks to its large and low-cost graduate pool. The country is the most cost-competitive destination among other low-cost destinations such as China, Russia and the Philippines. CRISIL Research believes that even at these suitability levels, India`s out-turn of graduates is sufficient to meet the demand of the IT and ITeS sector till 2010. The surge in demand for graduates in IT and ITeS industries has resulted in a corresponding rise in employee costs and attrition. At 16 per cent, India has one of the highest wage inflation levels among low-wage destinations. However, players have so far been able to offset the impact of wage inflation on margins by expanding the base of the manpower pyramid. Extent of competition Since large players dominate the IT industry, the scale is important to survive and grow. Even the IT software industry in India continues to be dominated by large players. Top five companies account for about 50 per cent of the industry`s income. Over the medium term, global majors in India are also expected to undertake expansion of their facilities to take advantage of the offshore delivery model. Given the fact that the size of a player is a key criterion in vendor selection, we expect consolidation within the market to increase over the medium term. Thus, the level of competition in the medium term is expected to remain moderate, with a likely increase in the long term.

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Financial risk
IT - Services: Financial parameters
Select financial parameters Aggregate turnover Operating profit margin Return on capital employed Net profit margin Interest coverage ratio Debt-equity ratio Current ratio Raw materials days WIP holding days Finished goods days Debtors days Creditors days No. of companies Source: CRISIL Research unit Rs million Per cent Per cent Per cent Times Times Times Days Days Days Days Days No 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 51,631 28.0 32.1 20.5 14.1 0.1 3.8 41 1 7 66 34 15 86,816 104,896 132,674 169,745 313,653 436,583 607,870 32.6 33.0 29.6 47.5 0.0 4.2 50 1 4 65 28 15 33.4 30.3 27.9 47.3 0.0 4.7 48 1 3 70 32 15 29.2 24.3 22.7 47.0 0.0 3.7 32 0 2 68 37 17 26.6 27.1 21.2 40.2 0.0 2.8 29 0 2 70 35 17 28.2 34.0 22.3 50.8 0.0 3.3 30 0 1 59 32 17 27.3 34.7 22.5 46.8 0.0 2.9 35 0 1 66 34 17 27.3 35.7 22.9 44.3 0.0 3.2 33 0 1 65 34 17

Note* - Revenues of Tata Consultancy Services and Patni Computer Systems Limited have been considered from 2002-03 onwards

IT - Services: Cost aggregates


Cost structure (% of net sales) Raw material cost Power and fuel cost Other operating costs Employee cost Selling cost No. of companies Source: CRISIL Research Unit Per cent Per cent Per cent Per cent Per cent No 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 17.7 0.9 6.4 24.7 4.1 15 9.8 0.8 5.5 29.3 3.5 15 7.7 0.8 5.2 33.0 2.2 15 5.8 0.8 6.8 35.3 2.0 17 5.1 0.7 7.4 45.7 2.1 17 3.7 0.7 8.0 47.0 1.7 17 3.6 0.8 8.9 46.5 1.4 17 3.4 0.8 9.8 46.9 1.2 17

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Annexure
Companies used for calculating sector aggregates
Aftek Ltd. Aztecsoft Ltd. H C L Technologies Ltd. Infosys Technologies Ltd. Infotech Enterprises Ltd. K P I T Cummins Infosystems Ltd. Tech Mahindra Ltd. Igate Global Solutions Ltd. Mastek Ltd. Mphasis Ltd. Tata Consultancy Services Ltd. Patni Computer Systems Ltd. Polaris Software Lab Ltd. Sasken Communication Technologies Ltd. Satyam Computer Services Ltd. Wipro Ltd. Zensar Technologies Ltd. The above sample list of companies accounts for 77% of total industry turnover

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IT - Services: Business risk evaluation


Risk entity name Business risk Operating efficiency Access to cost-effective technology Capacity utilisation Availability of raw materials Energy cost Raw material usage Management of price volatility Product design and development Adherence to environmental regulation R&D activities FCA/MDA approved plants Efficiency of beneficiation process Availability of skilled labourers Hygienic processing facility Indigenisation level Integration of operations Multi-locational advantage Selling cost Employee attrition rate Vulnerability to event risk Bargaining power with suppliers Proximity to customers Market position Brand equity Customisation of product Project-management skills Size-related pricing advantages Diversified markets Replacement markets After-sales service Proximity to market Long-term contracts/assured offtake Distribution setup Financial ability to withstand price competition Access to patents Consistency of quality Product range Deficit region Value addition Consolidation of markets Support service facilities Other promotional ventures Source: CRISIL Research Weightages 100 60 15 40 15 30 40 30 20 25 25 -

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