IT Sector: Q4FY22 Preview

India’s 8% global share in computer (IT) and other business services (ITES) in 2020 is a record high. Indian IT/ITES exports growing much faster than almost all peers and India is practically the second-largest globally, next only to the US. 

While MNCs setting up captives (through rising FDI) may be a short-term negative for Indian IT (greater wage pressure due to manpower demand, less outsourcing), eventually the relationship turns symbiotic. Recent developments in eastern Europe are likely to further solidify India’s position in IT exports.

The pandemic has led to a steep fall in indirect costs helping avert any marked dip in the margin. Rupee depreciation is likely to offer tailwinds in FY23 as some of these cost advantages reverse.

The industry is expected to report a TTM revenue growth to record a fifth successive acceleration in Q4 FY22. With the normalization of the base, this is likely to be the best sequential growth of recent times.

Despite strong year-on-year growth, with revenue normalization, quarter-on-quarter growth for the industry is likely to drop marginally in Q4FY22.

For most companies, employee productivity is steady in Q4FY22. The decline in Q3 was more on account of lower utilization as companies build surplus capacity. 

Longer-term growth trends remain positive from a productivity perspective, taking into account higher offshore that has happened over the last 2 years. HCL Technologies (bigger products portfolio) and Infosys have also above-average productivity while First Source Ltd (being the BPM player) is lower than others.

After four successive quarterly rises between Q2FY21 and Q1FY22, utilization dipped in the next two quarters. A continued modest drop in utilization is expected during Q4 FY22 as well. This is reflective of companies building capacity amid higher attrition. 

Despite some decline in Q2 and Q3 FY22, average utilization remains 100-200 bps higher than the pre-pandemic average.

As expected, industry headcount was at its peak in Q3. With the slight exception of Cyient and First Source Ltd, all companies reported record headcount in Q3 FY22.

While a few including TCS and Infosys reported record net headcount addition, for the industry, net addition dropped in Q3FY22 although marginally versus Q2.

Net headcount addition declined sharply in Q3 FY22 for TechMahindra and B soft. It also turned negative for the latter and also First Source Ltd. Birlasoft relied on subcontractors to cover up for the shortfall.

After 5 quarters of strong net headcount addition, the number is likely to come down in Q4 FY22. Yet, it would be higher than the pre-pandemic averages. Most companies recorded 20 to 30% attrition in Q3 FY22. The rate is relatively low for TCS and Coforge high for BSOFT (due to headcount reduction), Cyient, and Mastek. A modest dip in Q4 in quarterly attrition is expected, it is likely that LTM attrition would take time to cool off. Wage pressure is likely to be a little lower in FY23 as the year progresses and hiring cools off. Rupee depreciation also supports margins. 

Indirect costs are likely to have bottomed out in Q3. As lockdown restrictions get removed in most parts of India and the world in Q4, these costs are set to rise. While indirect costs for all are down vs. the past, savings are more for companies with higher costs in the past such as Intellect and Cyient as they focused more on gaining efficiency.

 The industry EBITDA margin has expanded from 16% to 19-20% since FY18. In Q4, at 20.1%, the industry margin is expected to be a bit lower than the record high. EBITDA margins are expected to dip from four-year highs for almost all during Q4 FY22. Few of the large caps including HCL Technologies and Wipro have seen substantial margin dips due to various reasons.

The industry TTM PAT growth in Q4 is expected to be at 16.9%, versus 16.2% in Q3. Year-on-Year growth was also likely to accelerate in Q4 (vs. Q3). QoQ PAT growth fluctuated between 3-6% during FY22 till Q3. It is expected to drop to 1.5% in Q4. 

Like EBITDA, industry PAT margin has expanded, from 10-11% till FY20 to 14% thereafter. Since Q3 FY21, the PAT margin has been around 14%. Despite a modest dip, a margin of 13.6% is expected in Q4. Despite superior margins of TCS and Infosys, the trend of higher-margin for large caps may not play out in Q4 FY22 with HCL Technologies and Wipro experiencing lower than trend margins.

The upside risk is the longevity of the high growth rate and the downside risk is the second-order impact of a prolonged inflationary environment and geopolitical dislocation.