The Indian IT industry had been a consistent performer through the first three quarters of FY22 and posted robust numbers backed by strong demand from customers as the world embraced digital transformation more deeply.
The top-tier IT companies witnessed healthy deal signings as the global economy inched back to normalcy after the pandemic blues began to ebb.
The management commentaries from almost all the top IT companies instill confidence about the sustainability of demand which is likely to remain strong going forward and was also evident through the magnitude of deal signings. Continued hiring momentum offered further visibility on demand and deal ramp-ups.
The strong growth momentum witnessed in the first three quarters of FY22 hit a bump in the fourth quarter as some kind of moderation was seen in the fourth-quarter earnings over the high base of the December quarter.
From the universe of BSE 500, the revenue growth for the IT sector during the quarter ended March 2022 was merely 1 percent over the December quarter. The growth was 19 percent compared to the year-ago period, as per the data available on AceEquity.
“The Q4FY22 earnings were well below the street estimates and the major reasons include fast changing macro-economic conditions, slowdown of growth in global IT giants, inflationary pressure and supply side challenges,” said Mohit Nigam, Head - PMS, Hem Securities.
The sector’s bottomline dipped 328 bps sequentially but jumped 28 percent on-year due to low base of last year.
The supply side challenges posed a serious threat to the sector and as the employee attrition soared across companies, the employee costs witnessed a steep surge which impacted the margins of the sector.
The operating margins for the BSE 500 universe dropped 213 bps on year to 22.6 percent, while the net margins remained more or less flat at 16 percent due to lower utilisation, higher employee additions, return of the travel and facility spends, and attrition, partly offset by better pricing and operating leverage.
Tier 2 companies outpace Tier 1 peers
Tier 1 IT services companies registered revenue growth of 2.1 percent QoQ and 16.0 percent on-year in dollar terms. However, Tier 2 companies outpaced their Tier 1 peers with 4 percent QoQ and 27.0 percent YoY revenue growth in dollar terms. Management commentaries suggest that the demand remains intact and growth story should continue in FY23 as well.
Deal signings amid digital transformation
The deal pipeline remains robust, fuelled by continued strength in the demand environment. “Cloud migration continues to see strong traction, and companies would continue to benefit from this over the next 3–5 years,” said a report from the brokerage firm Motilal Oswal Financial Services.
Cloud migration, 5G, digital transformation, and IoT remain in focus along with renewed traction in cybersecurity. Native cloud applications would continue to be the major growth drivers for Indian IT companies over the long term.
Deal wins were up 32.9 percent QoQ and 19.2 percent YoY led by Tata Consultancy Services (TCS) with $ 11.3 billion of deals.
Margins
“The Q4FY2022 saw maximum misses in margins compared to last eight quarters, owing to higher expenses to backfill attrition, compensation increase, lower utilization and increase in travel and facility expenses”, said Ashis Dash, IT analyst, Sharekhan by BNP Paribas.
As companies have done higher fresher hiring through the last couple of quarters, it may take 2-3 quarters to be fully billable. “Levers such as pyramid balancing, better pricing, lower sub-contractor costs and operating leverage will help the IT firms offset margin headwinds through the course of FY23,” added Dash.
Outlook
Management commentaries indicated that demand remains strong despite rising macro concerns and experts expect the growth momentum to continue in FY23. “We believe that the demand driver of digital transformation remains intact as tech spending on transformation programme remains a key element for the enterprises to prepare themselves for new normal,” said Dash.
The revenue growth is expected to remain strong in Q1FY2023, led by strong deal intake, healthy deal pipeline and strong demand.
“The IT sector sees a good demand driven by cloud, digitisation, artificial intelligence (AI), and machine learning (ML). All of these are structural and here to stay for the long term,” said Arun Malhotra, Founding Partner and Portfolio Manager, CapGrow Capital Advisors. “We will keep witnessing newer technologies being adopted to make businesses more productive thereby resulting in higher deal sizes and higher spending on IT”.
Apart from the continued strong demand, “the rupee-dollar exchange rate could also be favourable over the next year, thereby aiding operating margins as well as the likelihood of large global companies revisiting their offshoring mix and outsourcing more work to India to mitigate the geopolitical risk in Eastern Europe”, said Manoj Trivedi, Co-founder, Jama Wealth.
However, rising macro risk, potential recession in the US and increasing interest rate can lead to trimming down of tech spending and this would be a potential back-ended risk to the growth assumptions for this year.
“While headwinds such as higher wage revision, supply-side challenges and return of travel and facility expenses are likely to weigh on margin performance in the near-term, IT services firms will able to flex certain margin levers such as pyramid balancing, better pricing, lower sub-contractor costs and operating leverage to offset these factors in the medium-to-long-term,” Dash said.
Many IT stocks have corrected in the range of 20-50 percent in the last 5-6 months, bringing the current valuations in a reasonable band now. Experts suggest that the downside is limited at these levels and have a positive outlook on the sector as its long term growth drivers remain intact.
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