Supply pressures behind the IT sector, 2023 may surprise: IIFL Capital Services

30 Nov 2022 , 02:25 PM

India IT has witnessed two years of intense supply side pressures, as strong rebound in growth post 2020 COVID shock resulted in sharp pent-up hiring across geographies. However, sharp shift in revenues to offshore locations, like India (500 basis points since Q4FY20), intensified a lot more pressure in the Indian IT hiring market.

Attrition surged from ~10% in Q1FY21 to ~30% in Q3FY22 (annualized); sub-contracting costs rose by ~250 basis points and multiple rounds of wage corrections followed. With global macro moderating and pre-emptive hiring by IT companies in past few quarters with higher proportion of freshers, supply side pressures have begun abating. While increased offshoring has structurally reduced visa-related risks, elevated sub-contracting costs can act as a margin lever, since travel/facility costs return.

Hence, analysts at IIFL Capital Services believe supply-side pressures are behind us and margin risks are to the upside, from here. Valuations have recovered from the bottom, though improved visibility on FY24 growth outlook could support sector multiples, in their view. Analysts at IIFL Capital Services continue to prefer Infosys, Persistent Systems and Cyient.

Demand environment not as weak as feared

Indian IT sector has seen moderation in revenue growth, as global macro worsened through 2022. However, contrary to investor concerns, the rate of slowdown and leading indicators (such as deal wins) has not decelerated rapidly, and has shown some signs of resilience. IIFL Capital Services’ interactions with IT companies suggest stable demand environment going into Q3, with pockets of higher-than-expected furloughs visible in some cases. Analysts at IIFL Capital Services note that demand slowdown had spread over most of the verticals in Q2, but the extent remained limited. Deal wins declared by the companies have also been stable, till now. Nature of deals is shifting back from digital to cost take-out and back-end transformation deals.

Peak of supply side pressures behind

Unexpected fast recovery in IT demand had put pressure on the supply side for talent across the industry, leading to: i) Significant jump in attrition rates ii) Increase in sub-contracting costs iii) Multiple rounds of wage corrections and hikes.
Despite that, cost per employee has not increased materially, given that the pressures were largely offset by shift to offshore, higher fresher hiring, INR depreciation, pricing improvements and operating leverage.

Multiple levers to ease supply pressures on margins in 2023

IT companies have taken a number of steps to solve supply issues like increased fresher hiring and re-skilling of existing employees. Annualized attrition is already trending down; hiring is normalizing and freshers are ready to become billable over next few quarters.

Companies under IIFL Capital Services’ coverage have added on an average 8% of their FY22 employees in H1FY23 itself – a large proportion of these have been at junior levels. Analysts at IIFL Capital Services believe as freshers are being trained and deployed, the supply-side pressures have started to ease. Additionally, offshoring mix for the industry has increased by ~500 basis points, since pre-COVID levels, which analysts at IIFL Capital Services believe is structurally positive for the sector, given that it: i) Reduces visa risks for the sector (approval rates have increased sharply over FY20/21) ii) Offshore revenues have higher margins iii) Provides access to a larger talent pool. The currently elevated subcontracting costs would act as a tailwind, offsetting the increased travel and facility costs.

Mid cap valuation premiums have shrunk

Mid-cap IT stocks have underperformed large caps under IIFL Capital Services’ coverage YTD, leading to the midcap 1YF P/E premium reducing to 13% versus 40% a year ago. While analysts at IIFL Capital Services believe the reduction in gap was due to the perception that large caps are better equipped to handle a downturn, given the widening growth differential, they see more broad-based potential upsides in mid-cap names.

They continue to prefer Infosys as their top large-cap pick, while continuing to favor Persistent Systems as the top mid-cap pick; Cyient provides valuation comfort and optionality.

LTI-MTCL merger incorporated

Analysts at IIFL Capital Services have dropped coverage of Mindtree, as the stock has suspended trading post merger with L&T Infotech; resulting in merged entity LTIMindtree. They rate LTIMindtree as BUY with a 12-month target price of Rs5,450, based on 2YF P/E of 25X (same as LTI and MTCL) with 10% potential upside, after incorporating the above-mentioned merger.