Margin pressure

Next few quarters will be tough for IT sector

As the rupee trends down, can the IT industry ride high on its overseas income? Or will a combination of rising costs, skill shortages, and the threat of a possible global recession derail growth? The first quarter results and associated management guidance indicate squeezed margins. While companies are confident about “deal-wins”, they all complained about margin pressures and elevated attrition. The Nifty IT index has seen a 30 per cent correction since January 2022, which is much worse than the almost 6 per cent fall in Nifty. In earlier periods, when the rupee had been under pressure, the IT industry was a haven for investors given its unusual combination of dollar (and other hard currency) earnings coupled with the largely rupee-denominated labour costs.

The latest results, however, suggest margins are under pressure, and there are signs that demand may be easing off as overseas clients cut back discretionary IT spending. Consider the “big four”. Infosys saw rupee-denominated profits rising just 3 per cent, year-on-year, despite a 24 per cent rise in revenues. Operating profit margin (OPM) eroded by 3.5 per cent. Tata Consultancy Services saw OPM slide by 2.5 per cent, while Wipro’s OPM dipped to its lowest level in four years, and HCL Technologies also saw margins hitting multi-year lows. There are similar trends of falling margins and flat profits across smaller IT firms. Tech Mahindra has seen a 2.25 per cent dip in OPM, for instance. The industry is being hit with negative trends across multiple variables. Employee costs are rising; office rentals have gone up; and travel costs have increased. Attrition rates are running at over 20 per cent for major firms. Anecdotal evidence suggests India’s unicorns are competing to hire the same talent, and the rates for subcontracting work to boutique outfits have also risen because of the demand from start-ups.

 

At the same time, overseas clients are re-examining corporate IT budgets and focussing on essential expenses. They are also negotiating hard for lower dollar rates as they are well aware of the rupee-dollar trend. So revenues are being squeezed even as costs are rising. While Western Europe looks headed for recession, it’s possible that North America will merely see a slowdown. Certainly, most companies seem optimistic about maintaining the pace with respect to new contracts. Interestingly, some analysts see the likelihood of rising revenues from the EU precisely due to recessionary conditions there. West Europe is increasingly looking to outsource and cut costs. Apart from this counter-intuitive possibility, overseas clients everywhere will continue to move to cloud, fully digitised services, analytics, artificial intelligence and metaverse-related projects because all this is driven by structural factors.  But the near-term focus may be on cost-cutting.

Even global digital giants like Alphabet and Meta are acknowledging they are under pressure as they cope with falling valuations. Clients in banking and financial services are tightening belts as they face higher policy rates, while manufacturing everywhere is struggling with supply chain disconnects and low consumer demand as inflation bites. Market correction on this scale is an indicator. The consensus opinion seems to be that IT revenues and profits could hit roadblocks in the near term. While the industry should enjoy long-term structural demand, the severe talent shortages and the current recessive global climate will act as constraints on profitability.