Industry Risk Score

CENTURION BANK OF PUNJAB October 2007

IT-enabled 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 5 5 6

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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, a Standard & Poors Company CRISIL is Indias leading Ratings, Research, Risk and Policy Advisory company. CRISILs majority shareholder is Standard & Poors, a division of The McGraw-Hill Companies and the worlds foremost provider of independent credit ratings, indices, risk evaluation, investment research and data. CRISIL offers domestic and international customers a unique combination of local insight and global perspective, 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; gas, infrastructure and corporate advisory; research on Indias economy, industries and companies; global equity research; fund services; and risk management. For more information, visit http:/www.crisil.com About CRISIL Research CRISIL Research is India's leading 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 500 domestic and global clients, through a range of subscription products and customised solutions. We provide our clients with a vital competitive advantage in todays dynamic environment - Knowledge for Action.

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 Score 6.6 CRISIL Research believes the IT-enabled services (ITeS) industry has enormous export potential. However, it continues to be affected by high attrition rates and rapid commoditisation of services, such as call centres and transaction processing services. Additionally, the probable phasing out of the STPI scheme and imposition of Minimum Alternate Tax would probably hinder growth of the industry. We expect industry revenues to grow at a CAGR of about 21 per cent to reach $21 billion in 2011-12 from an estimated $8.1 billion in 2006-07. The most critical input for the ITeS industry is human resources. CRISIL Research believes that even at relatively low suitability levels, Indias turnout of graduates is sufficient to meet the demand for graduates arising from the IT and ITeS sector until 2010. Hence, Indias high growth in ITeS exports can be attributed to its abundant supply of skilled and qualified manpower. However, the industry quotes that around one of every eight persons interviewed (that is, 12.5 per cent), is selected for employment. If this ratio is applied to the required labour pool, then CRISIL Research estimates a dramatic rise in the actual labour pool required to satisfy the manpower requirements of this sector. Many players have entered the market, as the industry is not capital-intensive. The intense competition for skilled manpower has resulted in attrition and a consequent increase in training costs and employee wages.
Parameter IT-enabled 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 6.6 6.1 8.0 7.0 5.0 5.0 9.5 8.7 10.0

CRISIL RESEARCH IT-ENABLED SERVICES: OCTOBER 2007

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Background
The term IT-enabled services is distinctive to India as these services are commonly referred to as business process outsourcing (BPO) services, globally. However in the Indian context, the term ITeS is used to refer to a range of IT-intensive processes or services that are performed or provided from a distant location distinct from the users and delivered over telecom networks. The ITeS/BPO industry took root in India in the late 1980s, with British Airways setting up a small captive centre for its global data entry requirements. In the 1990s, other large global corporates such as American Express and General Electric (GE) installed their own captive centres in the country for back-office transaction processing. This was largely an outcome of liberalisation and telecom sector reforms. The idea was to convert India into a hub for worldwide back-office processing requirements. In 1998, GE offshored voice processes from India by setting up a call centre for the first time. Since then, the industry has grown by leaps and bounds. Industry revenues have grown at an estimated CAGR of 32 per cent from $2.4 billion in 2002-03 to $8.1 billion in 2006-07. The robust growth has been driven by the growing preference of corporates in the US and UK for outsourceoffshoring. They have either set up captive centres in India or have outsourced services to third-party service providers. These corporates include JP Morgan Chase, Swiss Re, World Bank, Ford Motors, Siemens, Sony, Sprint, Yahoo, Microsoft, Dell and Wal-Mart, among others.

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Industry risk parameters

Score 6.1

Demand-supply Score 8.0 The ITeS industry is expected to have tremendous growth potential in exports and healthy macroeconomic conditions. The industry has witnessed sturdy growth over the past five years, having grown at a CAGR of 32 per cent to reach an estimated $8.1 billion in 2006-07. We expect this momentum to moderate over the medium term. The growing need to cut costs has made it imperative for corporations across the world to consider offshoreoutsourcing. As the offshoring pie grows, Indian companies are expected to be major beneficiaries, given the availability of a large, low-cost, highly-skilled graduate pool and a 24x7 working cycle. CRISIL Research expects revenues of the Indian ITeS industry to reach around $21.1 billion by 2011-12, growing at a CAGR of around 21 per cent from $8.1 billion in 2006-07.

Revenues of the Indian ITeS industry

25 21.1 20 CAGR = 27% ($ billion) 15

10 CAGR = 34% 5 2.5

8.1

0 2002-03 2006-07 20011-12 P

P: Projected
Source: CRISIL Research

An increasing number of businesses are adopting offshoring practices in order to reap potential rewards such as improving operational performances, access to relatively low cost labour, and create value for shareholders. An expanding global pie, coupled with rapid expansion of global ITeS players has boosted the acceptance of the offshore delivery model. These factors would aid the growth prospects of the Indian ITeS industry, going forward. Government policies Score 7.0 Given the export potential and employment generation opportunities of the industry, favourable domestic policies have been framed to benefit the sector. The STPI scheme was one such measure, which benefited the industry tremendously. Some of the positive government policies for the ITeS sector are:

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Exemption of profits of companies located in, or registered under software technology parks (STPs), 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 industry has also been permitted duty-free imports of various capital goods. Also, 100 per cent foreign investments are permitted in the sector through the automatic approval route.

However, the income-tax holiday period is nearing its completion in 2009-10. Uncertainty exists regarding further extension of the holiday period. Therefore, in case of the holiday period not being extended or alternate benefits not provided, growth of the industry could be hampered, going forward. In the Union Budget 2007-08, a Minimum Alternate Tax has been imposed on the domestic IT/ITeS industry. This may impede the growth of the domestic ITeS sector. Input-related risk Score 5.0 As mentioned earlier, human resources form the most critical input for the ITeS industry. In fact, Indias high growth in ITeS exports can be attributed to its abundant supply of skilled and qualified manpower. As demand for the ITeS industry grows at a high double-digit pace, pressure on the supply of skilled and talented manpower also keeps rising. Most of the demand for employees in the sector was met through graduates, till date. Although, given the high number of colleges in the country, the supply of graduates is not a major constraint for the sector, the supply of a large number English speaking graduates and skilled manpower to provide knowledge-based services (services that require a good understanding of the clients domain, in addition to process expertise) is an imminent concern. Indian companies need to look beyond the labour-cost arbitrage and focus on developing specific skills. The unavailability of middle-management employees with good front-end skills is seen as a hindrance to the growth of the industry. A recent study carried out by McKinsey on the supply of global labour force, reveals that the employable graduate pool accounts for a 16.7 percent of the large graduate pool available in low-wage nations. CRISIL Research believes that even at these suitability levels, Indias turnout of graduates is sufficient to meet the demand for graduates arising from the IT and ITeS sector until 2010. However, according to industry sources, one of every eight persons interviewed (12.5 per cent) is employable. Given this ratio, CRISIL research believes that the actual labour pool required to satisfy the manpower requirement of the sector would rise dramatically. Therefore, given the intense competition for manpower, the industry is witnessing high attrition rates (above 30 per cent in voice-based services and transaction processing services). This, in turn, has resulted in high training and development costs for companies. Furthermore, wage bills in the ITeS industry have been on an upward trend. According to a recent Hewitt study, in 2005-06, voice operations of the ITeS industry in India recorded an average wage bill increase of 8 per cent, while for non-voice processes it was still higher at 11 per cent. In some instances, players across the voice and non-voice segment quoted increments as high as 13 per cent and 17 per cent, respectively. On an average, salaries at the middle management level increased by 5 per cent and at the senior management level

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CRISIL RESEARCH IT-ENABLED SERVICES: OCTOBER 2007

by around 10 per cent. CRISIL Research believes that such wage inflation is not likely to subside going forward, given the high attrition rates and increasing demand for talented/skilled manpower. In addition, the rupee has also appreciated by more than 9 percent in the last three months. CRISIL Research believes that this will exert pressure on the operating margins of the export players by around 300 basis points. Extent of competition Score 5.0 The ITeS industry is marked by fierce competition owing to its fragmented nature. Moreover, there is growing competition from other low-cost locations. With over 3,000 companies in the ITeS segment in India, intense competition has resulted in acquisition of smaller players by their larger counterparts. With high demand for professionals, companies have resorted to poaching from competitors. Also, increased attrition rates in the voice segment have resulted in higher training costs and paucity of professionals for companies. As the ITeS export market is gaining traction at a faster pace, it is poised to become the most popular sector for investment. Captives, who are loosing their hold to Indian Third Party Vendors (TPVs), dominate the market, no longer. As many more captives lose out to Indian TPVs, competition among service providers is heating up. Financial risk
IT-enabled 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 IT-enabled 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 1.57 2.29 11.80 34.99 2.90 6 1.48 2.15 15.42 39.07 2.35 6 1.41 1.64 18.36 35.24 1.42 6 0.93 1.76 19.14 34.04 1.27 6 0.93 1.99 15.69 38.67 1.07 6 0.38 2.13 9.61 44.00 5.43 7 0.34 2.25 10.24 48.28 1.82 7 Days Days Days Days No unit Rs million Per cent Per cent Per cent Times Times Times 1999-2000 687.00 30.40 12.32 24.92 21.17 0.12 3.72 0 0 1 115 31 6 2000-01 1983.50 20.53 12.98 3.68 7.06 0.39 1.74 83 0 1 71 37 6 2001-02 3157.60 26.02 31.11 9.05 11.55 0.22 1.46 83 1 1 63 52 6 2002-03 4029.70 28.03 36.46 13.53 16.75 0.23 1.43 75 1 1 62 62 6 2003-04 4834.68 25.99 29.75 13.52 16.72 0.24 1.47 243 1 1 67 66 6 2004-05 9257.30 22.76 16.81 12.61 10.76 0.61 2.18 118 1 1 74 37 7 2005-06 11931.70 25.30 21.46 12.98 6.20 0.50 2.11 59 1 0 72 19 7

Score 9.5

CRISIL RESEARCH IT-ENABLED SERVICES: OCTOBER 2007

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Annexure
Companies used for calculating sector aggregates
Allsec Technologies Ltd Datamatics Technologies Ltd Citigroup Global Services Ltd Kale Consultants Ltd Ontrack Systems Ltd Tricom India Ltd Firstsource Solutions Ltd

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CRISIL RESEARCH IT-ENABLED SERVICES: OCTOBER 2007

IT-enabled 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 30 20 10 40 40 40 20 20 20 -

CRISIL RESEARCH IT-ENABLED SERVICES: OCTOBER 2007

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