Rising inflation, travel costs to bite into IT firms' margins: Analysts

Analysts are turning cautious on the information technology (IT) stocks as they expect the rise in inflation in the US, coupled with increasing travel costs for these companies to eat into the companies' margins going ahead.

This rise in inflation in the US, according to analysts at Jefferies, is one big factor that will see most IT companies hike wages going ahead. For Indian IT services firms, onsite employees form around 25 per cent of overall workforce, but nearly 60 – 70 per cent of their overall employee costs, Jefferies said.

"Over the past six months, the US inflation rate has moved up sharply to over 7 per cent levels. In the past, onsite wage inflation for Indian IT firms ranged between 1.5-2 per cent - in line with local inflation levels. If the current spike in inflation levels in the US sustains, then Indian IT firms may have to offer higher wage hikes onsite. A 1 per cent higher onsite wage inflation could lead to a 30 basis point (bps) margin drag," wrote Akshat Agarwal and Ankur Pant of Jefferies in a recent note.

Thus far in CY22, the Nifty IT index has underperformed the Nifty50 by falling around 7 per cent as compared to 3 per cent dip in the 50-share index during this period. On their part, foreign investors that have dumped nearly $20 billion worth of Indian stocks since October 2021 have seen their selling concentrated around the IT stocks among others, suggests a recent note by ICICI Securities.

Among sectors, FPIs sold IT stocks worth Rs 31 billion in the first half of calendar year 2021 (H1-CY21) as per the ICICI Securities note – the highest among peers. This picked up in the second half of the year (H2-CY21) with foreign investors dumping IT stocks worth Rs 209 billion during this period. The pessimism continued in January and February 2022 as well with FPIs selling stocks worth Rs 159 billion and Rs 110 billion in these two months respectively, the ICICI Securities note suggests. CLICK HERE FOR THE TABLE

Travel costs

Besides inflation, rising travel costs is another factor worrying analysts. Travel costs, which used to range between 2-3 per cent of sales dropped to 0.5-0.9 per cent during Covid, as per analysts' estimates. With rising acceptance of remote work/offshoring, while travel costs may not rise to pre-Covid levels, Agarwal and Pant believe even if they increase to an average level of pre-Covid and Covid periods, they could hit margins by 40-100 bps.

"On a net basis, 2 per cent higher onsite wage hikes, higher travel costs and replacement of subcontractors will impact margins of the Top-5 IT firms by 70-130bps. We lower our FY23-24 margins estimates by 10-60bps and EPS estimates by up to 3 per cent to factor this. We now forecast a 70bps decline in margins in FY23 and expect Top-5 Indian IT firms to deliver 7-15 per cent EPS CAGR over FY22-24," the Jefferies note said.

Those at IDBI Capital, too, believe that increase in facility cost (due to return to office), higher travel cost and onsite presence put pressure on margins. However, higher pricing, lower subcontracting cost, pyramid rationalisation and recent rupee depreciation will act as a tailwind to companies margins.

"The demand for IT is far stronger and there is a strong revenue visibility over the next few years. However, most of the positives have already been factored in the IT stocks. Remain cautiously optimistic and selective in stock picks. Our top picks in large-caps are Infosys and Tech Mahindra. Among mid-caps, we like Cyient, Zensar and Birlasoft," said Devang Bhatt, an analyst tracking the sector at IDBI Capital.

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