Over the past two years, IT services companies saw outsize gains in share prices as digital investments zoomed across industries post-pandemic. Even small and mid-sized businesses were investing heavily in tech infrastructure.

Now as Covid savings dry up and inflation bites, the tone among IT investors is changing and has grown more pessimistic. The largest, top-tier companies like TCS (check out our analysis here), posted results that have left analysts wondering how much gas is left in the growth tank, at least in the short term. 

Let’s take sequential revenue growth for instance. If we look at the dollar revenue growth of the top IT services companies (Tata Consultancy Services, Infosys, HCL Technologies, and Wipro), dollar revenue growth was tepid in Q1FY23, except for Infosys.

Bengaluru-based Infosys’ Q1FY23 dollar revenues stayed firm as it didn’t see any weakness in its European business. It was an exception - TCS’ and Wipro’s Europe revenues fell sequentially by around 2%-3%, and HCL Tech’s fell marginally by 0.2%. 

Despite the US being in a ‘technical' recession, revenues from the region have remained strong for the four companies.

But in these companies’ post-earnings calls investors and analysts saw a different emphasis—margins and pricing.

High attrition is a given, but margins suffer

It appears that analysts and investors have learned to live with high attrition in IT services companies. As companies fight it out for engineers in a tight job market, high attrition is a certainty. This hasn’t left even TCS unscathed as its Q1FY23 trailing-twelve month attrition was within touching distance of 20% (that’s one-fifth of employees leaving their jobs voluntarily). 

“The attrition is not totally unanticipated, but it is continuing and we think that probably it will take another few months before it will start to come down,” said TCS CEO Rajesh Gopinathan. “So, till then the margin pressures will continue but we hope to sequentially improve from where we are.”

Q1 is also a period when many employees resign and head for higher studies, so some of that effect is showing up here.

What stands out is the cooling of Wipro’s attrition levels. Although marginal, the fall in Wipro’s attrition in Q1FY23 is not getting out of control. This comes as the company’s spending on employee salaries continues to rise QoQ as a proportion of its revenues in Q1FY23.

Only HCL Tech’s employee costs fell on a sequential basis as a proportion of revenues because its salary hikes for employees kick in from Q2 onwards. The other companies rolled out pay hikes in Q1FY23 itself, while Infosys will roll out pay hikes for senior employees in Q2.

This doesn’t mean that another bugbear—high subcontractor costs—aren’t a problem. Most companies’ management acknowledged this number was elevated as a proportion of revenues. While Wipro’s subcontractor costs as a proportion of revenues fell QoQ in Q1FY23, it’s still way higher than normal.

High subcontractor costs across top tier players are largely because freshers and trainees can’t be deployed directly on projects. This leads to companies having to subcontract their requirement for more experienced engineers for such projects.

Although Q1 of the financial year is a weak quarter margins-wise for the tech sector, it’s still worth noting that all top tier IT services companies saw margins fall.

While companies have tried to retain employees with pay hikes, there is a considerable cost that comes with ramping up people's requirements in large deals. This impacts margins in the initial phases before revenue starts kicking in. HCL Tech’s margins came in below its guided range of 18%-20% for FY23, and despite a pending salary hike in Q2, the company’s management says its confident about meeting this guidance, albeit on the lower end. Infosys’ management also noted that the company’s FY23 would be at the lower end of the guided range of 21%-23%.

“We are going to look at costs much more aggressively, looking at utilization, and the subcontracting that we have built up because of (past) demand,” Infosys’ Chief Financial Officer Nilanjan Roy said at a post-earnings press conference. “We will look to optimize that over a period,” he added.

Margins were hurt because of higher travel and visa costs, but the management of all four companies expect offshoring of projects and operating leverage to eventually lift margins higher over the course of the year. But the situation right now is dynamic, and investors must be mindful of larger macroeconomic headwinds.

Some verticals see slower revenue growth

The growth in revenues from the various industry verticals shows quite a bit of divergence for Indian tech. Take for example the manufacturing vertical. TCS’ manufacturing vertical’s sequential revenue growth slowed and revenues were flat at $670 million. Wipro’s revenues from the same vertical also fell nearly 4% QoQ to $183 million.

On the other hand, Infosys and HCL Tech’s manufacturing vertical’s revenue growth were strong at 6.5% and 2.8%, respectively.

Among the four top-tier companies, only HCL Tech’s financial services vertical saw revenues grow at 2%, but from a low base, confirming a slowdown. Infosys’ management said that they are seeing a slowdown in the mortgage space, with the rise in interest rates in North America and Europe. This could intensify if rate hikes persist.

Infosys’ CEO Salil Parekh said in a post-earnings call with analysts that client volumes in the mortgage space have gone down “in the European and the US market. So our work there is proportionally reduced.”  Decisions by clients are also being taken more slowly in this space, but the pipeline still looks good, he added. This is what led the company to increase its FY23 revenue growth guidance to 14%-16% from 13%-15%. 

Parekh called out some weakness in the retail industry vertical, while TCS, HCL Tech and Wipro’s management didn’t call anything out specifically. Still, all four companies have posted strong sequential revenue growth. Rising inflation is the albatross for consumers, and could hurt retailer profits. But the management of top tier companies don’t expect any cut in spending.

This expectation of continued demand is what summarizes Q1FY23 commentary from the management across Indian IT. Although investors would do well to be cautious, stock prices have recovered for most IT companies with the recent bounce. 

But whether this exuberance will be rewarded the way it was over the past two years, is something only the Q2FY23 results will tell us. We will then get an idea of how well the business model of IT companies is holding up, in the face of macroeconomic headwinds across geographies.