IT majors face multiple margin issues

Slowing growth, stronger rupee and higher local hiring to pull firms down this financial year

Amid slowing growth and rising protectionism in the key market of America, Indian information technology (IT) companies are facing multiple margin headwinds for the next one year, at least.

Operating margins of most IT companies are closer to their historical lows. The sector has been grappling with structural and cyclical growth issues in recent times. These include the disruption caused by strong rises in client spending on digital technologies such as automation, the internet of things (IOT), cloud and data analytics.

These are very different from the traditional services offered by Indian IT vendors. And, entails smaller deals of lower tenure, as against the multi-year and large-size deals under the traditional model. This disruption has slowed revenue growth (in constant currency) for Tata Consultancy Services, Infosys and Wipro. HCL Technologies’ aggressive focus on the re-bid market, with continued acquisitions, have enabled it to grow at a healthy clip, relative to other majors.

Another headwind for Indian IT is rising protectionism in their key market of America. While most companies have stepped up local hiring in recent times to reduce the impact due to visa restrictions, this will have implications on their margins.

Though analysts believe there mighty not be such a big difference in what is paid to a visa-based worker and a local one, on a like-to-like basis, shifting to a visa-independent model will entail investment towards improving the availability of skilled local talent through training. Also, while it is easy to relocate a visa-based worker from one city to another in the US, this might not be true for a local. Third, and important, while the companies followed a ‘just in time’ hiring policy of visa-based workers as they bagged new projects, they might end by creating a ‘bench’ (sector jargon for those on the staff without new project work) while hiring more locals. Creation of a bench will pull down onsite employee utilisation rates from the current 90-plus per cent levels, taking down the margins as well.

This, with a stronger rupee, will exert pressure on the earning margins before interest and tax at leading IT companies. Parag Gupta, IT analyst at Morgan Stanley India, says: “There appears to be more downside risks to IT companies’ margins in the next 12 months than upside levers. One big headwind is rupee appreciation. With spends changing, companies will have to invest in their businesses, either in hiring new talent or retraining the existing ones.”

A lot of companies, he adds, are talking of growth coming back, particularly from the banking and financials segment. If that does not happen, the margins could further reduce.

“With rupee appreciation, impending wage hikes, the need to pre-emptively change onsite staffing and pricing pressure in legacy orders, top IT companies’ margins remain at risk,” says Ashwin Mehta, IT analyst at Nomura. He expects a fall of 70-130 basis points in operating margins of the top four IT companies in FY18.

While there are some margin levers available to them, these are more long-term in nature. One is automation, which will drive cost efficiencies and provide some support to margins. However, automation is currently a relatively smaller part of these companies' operations and will scale up only gradually. Also, increasingly, companies are looking at hiring more of freshers, which come at a lower cost than experienced talent.

Overall, while there are long-term margin levers in place, the pressures clearly outweigh these. Also, revival in revenue growth is of utmost importance to these companies. With the changing industry dynamics, it remains to be seen if this growth will come by giving away some margins.

In this backdrop, stock investors are better off placing selective bets on some large IT names, even as some trade at premium valuations versus their peers.