What a whirlwind of a few weeks it has been for investors in Indian IT services. Before the Q4 results, it was mostly positive commentary from analysts and industry heads, with everyone gung-ho about a secular uptrend in revenue growth. 

Then came the Q4FY22 outlook from analysts tracking IT spends. We dealt with it here briefly.

But we have been here before. When the pandemic broke out in India in March 2020, many analysts withdrew their earnings and target price estimates for Indian IT services companies. Managements at these companies were hoping that by the end of 2020’s calendar year (Q3FY21), they would post revenues at the same levels as the previous year.

But by January 2021, almost all IT services companies’ revenues were growing rapidly. Analysts and investors were predicting at least a few years of rapid revenue growth. Then came another surprise - large-scale attrition as the second wave of the pandemic waned in India at the beginning of FY22.

IT services companies are now faced with high demand for their services, even as clients are facing cost pressures and their own attrition issues due to ‘The Great Resignation’. L&T Infotech’s management in a conference call after their Q4FY22 earnings alluded to the fact that high property prices in the US are leading to people quitting jobs they were wedded to for many years.

As the US economy battles multi-decade high inflation caused by loose monetary policy, supply chain issues across the world, and the conflict in Europe, the feeling now among analysts and industry watchers is that US economic growth will slow. The ‘R’ word—recession—is back in our lexicon. As we all know, if the US sneezes, the world catches a cold.

What does all this have to do with mid-tier IT services companies? Well, everything.

Revenue growth keeps pace in FY22 but might slow

As the IT services space entered FY23, Q4FY22 results showed that revenue growth is slowing. L&T Infotech and Tech Mahindra’s (TechM) revenue growth slowed on a sequential basis in Q4FY22. This is despite both companies posting their highest-ever revenues in FY22.

Some companies like Coforge and Persistent continue to set the pace among mid-tier IT services companies, but they are on a smaller revenue base. Mphasis’ dependency on revenues from DXC is down to 5% of its total, and its revenue excluding DXC (direct business) has crossed the $400 million quarterly run rate in FY22.

Mphasis is one of the few mid-tier companies, apart from Coforge and Persistent, that is really confident of tiding over rough waters if the global economic cycle worsens. While the management of mid-tier IT companies are confident of revenue continuing to grow at a rapid pace, the broad-based downgrades by analysts of the IT services sector raises some worries for investors.

Margins to remain under pressure in FY23, with employee costs rising

The IT services industry as a whole is facing severe wage inflation concerns. This is beginning to weigh on the earnings before interest and tax (EBIT) margin. Take for instance the L&T Group companies. Mindtree’s EBIT margin at 18.9% is higher than its group company L&T Infotech (LTI). LTI is facing onsite attrition which is impacting margins. 

LTI will continue to invest in its sales force and anticipates its salary hike from April 1 onwards to hit margins by 290 bps in Q1FY23. (LTI and Mindtree will eventually merge and become LTIMindtree). 

Although rapid revenue growth can ease some of the margin pain, the main headwind is high inflation in the US and Europe and rising interest rates. This could lead to cuts in spending, which in turn could hurt margins.

Coforge doesn’t expect a cut in discretionary spends to affect it much, as it has an order pipeline of $720 million going into FY23, which is close to its $867 million revenue in FY22. The company’s management is confident of crossing $1 billion in revenue in FY23 and keeping margins in check.

Mphasis, Coforge, and Persistent have managed to keep their margin pressures under check as well with rapid revenue growth. It will be interesting to see whether this will continue with the overhang of macroeconomic issues in FY23.

Attrition and employee cost pressures to continue till the end of 2022

The one unhappy constant across the industry right now is employee attrition. If you look at the chart below, most mid-tier IT services companies lost a quarter of their workforce on a trailing twelve-month basis at the end of Q4FY22. Coforge is able to beat its peers here because of its higher ESOP costs vis-à-vis peers.

This has led to higher employee costs as a proportion of revenues. Only Tech Mahindra managed to keep its employee costs as a percentage of revenues below 50%, while most of the other mid-tier IT peers are at 60% of revenues.

Not all of these companies break out their subcontractor costs, but these are also impacting margins as a whole as companies have to resort to contract hiring of engineers to service projects. For context, Mindtree’s subcontractor costs are near 10% levels for the past four quarters, while TechM’s is near 15% levels.

With attrition rates near or above 25% for many IT services companies, the industry as a whole is changing their employee pyramid to include more freshers. While employees with niche skills help these companies get a higher rate from customers, driving a rush to poach these engineers from competitors, the industry as a whole is focused on hiring freshers.

We have specifically not dealt with verticals and service lines here because there is demand for IT services, cloud services, cyber security services, and many others, across various industries. The unknown here is whether customers will cut spending in face of pressure on their bottom lines. A recession in the US in the next 12-24 months will hurt IT spending. Some banks in the US are already anticipating losses from bad loans that are set to start rising in 2022 and beyond.

Investors should keep in mind that although analysts across the board have downgraded the IT services space, this could also be because the valuations were unsustainable. The consensus is that revenue growth will taper off in FY24, and from their vantage point at the beginning of FY23, some analysts are getting cautious. This has caused IT service companies’ stocks to correct. Still, their business’ demand environment - so far - is solid