After posting stellar revenue growth numbers for many quarters, investors knew that the party wouldn’t last for all Indian IT services firms. We looked at India’s top four tech companies’ Q1FY23 performance here. The expectation of higher technology spends due to ‘multi-year technology upgrade cycles’ and ‘cloudification’, drove IT stocks higher over the past few years. But now some realism has set in.

Investors are getting a clearer picture on future growth for mid-tier tech from the dollar revenue growth for these companies in Q1FY23. Mindtree managed three consecutive quarters of 4% QoQ growth in Q1FY23, but L&T Infotech, Coforge, Mphasis and Tech Mahindra slowed considerably in the quarter.

Mindtree’s steady revenue growth was helped by its mainstay communications, media, and technology vertical posting 5.9% QoQ revenue growth. This helped offset weakness in the company’s retail, CPG, and manufacturing vertical.

The outlier in mid-tier IT services is Persistent, which posted double-digit revenue growth in Q1FY23. The 9% compounded quarterly revenue growth for five quarters was led by strong organic revenue growth, which helped dampen the impact of lower intellectual property revenues during the quarter.

Like their top-tier counterparts, all these companies expect a better H2FY22. But should investors look at mid-tier IT companies differently, considering past rapid growth that had outpaced the big guns?

As expected, margins took a hit. But not for everyone

There is intense competition for talented engineers in the tech industry globally, and Indian mid tier companies aren’t immune. But this isn’t hitting their margins across the board.

Mindtree’s Q1FY23 EBIT margin rose QoQ, despite rising nearly 6% QoQ to around Rs 1,854 crore. Its consistent QoQ revenue growth helped the company overcome one-time merger related expenses that pulled down the EBIT margin by 50 bps. If not for this one-time expense, its EBIT margin could have been 19.7% in Q1.

Travel and visa-related costs were muted over the past few quarters due to the pandemic, and this has now returned with a vengeance. This, coupled with pay hikes across companies has impacted margins. Still, Mphasis and Persistent were able to sustain their margins in Q1FY23.

Another factor that has hurt margins across the board is low employee utilisation. The entire tech industry in India, especially IT services companies, is trying to hire engineers. With skilled engineers commanding a high price, IT companies are resorting to hiring freshers. Even a company like Mphasis which never used to hire freshers, is hiring graduates fresh out of college. Companies hope that reducing costs with fresh hires will make them competitive while bidding for contracts, and right-size their employee pyramids.

Companies have to pay these newly hired engineers when they are on the bench, even when they are not on projects. This has led to lower employee utilisation across the board and hurt margins as companies can’t bill these engineers to clients.

Tech firms point to lower employee utilisation and slower ramp-up of large projects as the cause of lower margins and revenue growth in Q1FY23. Once large projects ramp up and engineers start manning projects, profitability will rise. At least so say the management of all the mid-tier companies. This is probably why the Nifty IT is inching upwards after the early disappointment of tech results.

Employee costs are still elevated as a proportion of revenues.

Only Mindtree and Persistent saw employee costs fall QoQ as a proportion of revenues in Q1FY23. This is due to faster revenue growth for the duo.

Elevated employee attrition is something that is concerning as this can continue to hurt margins. Surprisingly, Tech Mahindra and Persistent managed to control runaway attrition levels during Q1FY23. Persistent’s rapid revenue growth helped limit the impact of high attrition on its margins.

Tech spends focus towards efficiency, as industries prioritize digital infrastructure

Contrary to analyst worries that tech spends will slow, due to at least short upcoming recessions in the US and Europe, tech companies are positive on client spending. This is partly because the previous two recessions which led to falling tech spends, are different from what is happening now.

No business is immune to macroeconomic headwinds that lead to lower-end–customer spends in retail, which in turn impacts technology spends and revenues. Higher interest rates set by global central banks will also impact mortgage lending, and revenues from this sub-vertical for Indian tech services companies. However, most clients across industries are aiming for digital agility while serving customers. 

Investors should note that the transition to cloud infrastructure across industries, and the growing need to be a digitally native business, will drive technology spends. The conflict in Europe did lead to some weakness in Eastern Europe for tech companies, but this looks transitional. The deal pipeline is healthy for all mid-tier IT companies, and the order book is robust. They are mining clients and bagging large deals as well.

Investors might have to be cautious about which horse they bet on in this race.  But all mid-tier companies are experiencing similar issues in the short-term: lower employee utilisation due to fresher hiring, higher attrition of talented engineers, and the slow ramp-up of large deals. The tide however may turn soon, making some of these companies attractive bets