Why top IT stocks could face a margin pressure in the short term

The Covid-19 pandemic gave an impetus to the technology sector at large due to accelerated demand for digitisation but it also exposed the considerable demand-supply gap, especially for digital tech talent in the Indian IT industry.

This has led to an unprecedented surge in the attrition rates for the industry in recent quarters. Increasing opportunities for tech talent with specialised skills such as cloud, cybersecurity, artificial intelligence, machine learning and others besides a shift in work-life dynamics have been some of the key factors for the rise in attrition.

Employee cost as a percentage of operating income for the top five listed IT companies has increased steadily in recent years from around 51% in FY2021 to almost 55% in FY2022.

The contraction in operating profit margins due to wage inflation has been around 250-350 basis points over the past year for most major IT companies.

The training and incubation costs for fresh hires recruited over recent quarters and higher remuneration to retain existing talent will continue to result in wage cost inflation, leading to likely moderation in operating margins by 100-150 basis points over the next few quarters, according to rating and research agency ICRA.

However, margins are expected to improve over the medium term supported by stabilisation of wage costs with some optimisation of the employee pyramid, better realisation and employee utilisation.

The growth momentum witnessed over the past year-and-a-half is expected to sustain over the medium term, driven by healthy demand environment with strong traction on the digital services front.

On the positive front, revenue visibility for most IT companies increased considerably in FY2022 on the back of sizeable addition to total contract value. To combat the surge in attrition, hiring activity picked up considerably from H2 FY2021 onwards and there was record net employee addition of around 4.5 lakh for the industry in FY2022.

Given that the demand momentum is likely to sustain, hiring activity is expected to remain buoyant over the medium term.

The industry employee base is expected to grow by around 7% to around 5.3 million by the end of FY2023.

Additionally, normalisation of operational overheads with easing of Covid-19 related restrictions has also exerted some pressure on operating profit margins. However, the same has partly been abated by better pricing, especially in the digital services domain.