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This Could Devastate India’s Prized IT Sector

Friday, 24 May 2013 | 3:37 AM ET
Bloomberg | Getty Images

India's prized $108 billion information technology (IT) services sector is on a "knife edge" in the face of a looming vote on the U.S. immigration reform bill, which threatens the very business model the industry thrives on, says Nomura.

"We believe the U.S. immigration bill, if passed, would disrupt the current Indian IT business model, place it at a competitive disadvantage versus multinational companies and depress margins irrevocably," wrote Ashwin Mehta, regional head of software and services research at Nomura India in a report published on Friday.

The immigration reform bill, which is expected to be discussed and voted on in the U.S. Senate in June, addresses a range of issues. But what is critical to India's IT services industry is a proposal to restrict firms in the U.S. that employ foreigners, on the H1-B visa for high skilled foreign workers, from placing these employees on client sites.

Employers with 15 percent or more of their U.S. staff on H-1B visas, which includes all Indian IT companies, would be subject to this restriction, according to Nomura.

(Read More: Kudlow: Immigration Reform Is Pro-Growth)

The majority of IT services staff in the U.S. are typically posted at customer sites, so this would disrupt the arrangement and mandate placing only local employees at client offices.

"Outplacement debarment not just hits the current growth and margins of Indian IT companies, but is also likely to have a longer-term growth impact on the reduction in competitive advantage," said Mehta, noting that the firms would be forced to hire more local employees and set up new bases near client locations – pushing up their costs.

"It [the bill] has the potential to flatten sector earnings with margin drops of 150-400 basis points [1.5-4 percent] across companies over fiscal years 2013-2016," he said.

The bill includes other proposals that would dampen profit margins at these companies including an increase in visa fees for firms that have over 30 percent of their U.S. workforce on an H-1B visa, and a hike in salaries for the visa holders on the argument that foreign workers are being used to undercut American employees.

(Read More: Immigration Reform to Cost $6 Trillion: Study)

There is a high likelihood of the bill passing with all the "damaging proposals" in the Democratic-led Senate, Mehta said, noting that support building among Republicans towards immigration reform increases chances of the bill being passed in the House as well.

Based on their relative reliance on H-1B employees, salary levels, and dependence on the U.S. for revenue, the impact is likely to be the most severe for Mumbai-listed Tata Consultancy Services (TCS), followed by Infosys, Wipro and HCL Technology, Mehta said. TCS, for example, derives approximately 50 percent of its revenues from North America.

"We find tier-1 IT stocks not factoring in any element of risk due to this bill," he said, noting that the bank has downgraded its recommendation on TCS and Infosys to "reduce" or underweight.

(Read More: Rubio: Now Is the Time to Pass Immigration Reform)

The bank forecasts downside of 8-11 percent for the stocks, respectively, over the next 12 months if the bill is passed in a diluted form. In the worst case scenario of all provisions being passed, the correction could be as high as 30 percent, he said.

Shares of TCS have remained resilient this year, up 17 percent, outperforming gains in the benchmark Bombay Sensex which has risen 2 percent over the same period. Infosys, meanwhile, is up just 1.4 percent on concerns over the company's earnings outlook.

By CNBC's Ansuya Harjani