IT Sector: Growing demand leading to supply-side cost

IT services industry in India is in the early phase of a multi-year technology upcycle with spending on digital transformation earlier planned for the next decade now being compressed into a 3-5-year period. Digital leaders are racing to widen the gap and digital laggards are racing to leapfrog to stay ahead of the competition. 

Enterprises are spending on technology to not only reduce costs but also to enhance their business model to stay relevant to their customers. Technology spending is now directly linked to driving higher revenues, and hence, are shifting from cost of operations to a cost of revenue and becoming a bigger proportion of client’s revenues. 

Clients in the US and Europe are facing the highest ever wage inflation in the past 20 years with annualized wages rising 4.5-5% YoY. There are 10.5million job openings, against 7.4million unemployed workers in the US. The scarcity of tech talent in developed markets is driving up demand for automation and offshoring.

While the transition to the cloud has been ongoing for a few years, covid has accelerated cloud adoption due to higher resilience, the shift of costs from CapEx to Opex, and ‘anywhere, all-time’ connectivity provided by cloud-based platforms. 

Enterprises across sectors and markets have realized that adoption of the cloud increases their ability to respond to rapidly changing customer needs, a key competitive differentiator. Cloud facilitates rapid prototyping and innovation and helps speed time to market.

A surge in cloud adoption translates into strong growth for IT service providers on the back of cloud platforms created by them to help speed up the cloud transformation journey of clients thereby improving the utilization of cloud capacity subscribed by clients and thus translating bookings into revenues for Hyperscalers partners.

IT services are very critical to Ukraine given that its IT services exports of $6.8billion (36% YoY account for 4% of its GDP. One in five Fortune 500 companies use Ukrainian IT services and, of its total IT services exports, 50% is exported to the US and UK. As per ISG, there are about 50,000 tech workers and 200,000-odd technology freelancers in Ukraine who could be affected by the hostile situation because of the Russia-Ukraine war. 

The supply-side impact for Indian IT services is not material due to limited presence in war-affected east European countries. In fact, there is a high likelihood for Indian IT services to gain market share from providers like EPAM who have a high presence in Ukraine. Our channel checks suggest that select Indian IT companies have started getting massive inquiries from clients in areas such as business continuity support, data, and cyber security. 

Indian IT companies have started getting massive inquiries from clients related to EPAM, especially. As of now, inquiries towards business continuity support and data security, and cyber security are quite high. Cyber security, supply chain resiliency, and energy efficiency are also top priority enterprises due to the Russia-Ukraine conflict.

Higher inflation will likely lead to postponement of discretionary spending, and focus on cost optimization will increase. A higher focus on cost will likely lead to a dampening of tech budgets and reduce discretionary spending. Even Gartner reduced its forecast of CY22 IT spending to grow at 4% (vs 5.1% earlier) and that of IT services to grow at 6.8% (v/s 7.9%).

IT companies highlight the strength in demand is broad-based across verticals, markets, and service lines. BFSI, technology services, and healthcare verticals were the first to recover followed by retail, manufacturing, and communications. The sectors worst hit by pandemics – such as travel, transport, and hospitality – have come back to pre-covid levels for most of the IT companies. Clients across verticals have realized the power of technology in enhancing revenues. 

The urgency of digital transformation is changing the nature of demand. The client’s willingness to give purchase orders of 3 to 5 years is lesser as compared to giving orders in sprints – as they target faster execution of projects. However, once an IT services vendor wins the short cycle project, it does not have to compete with other vendors to win subsequent sprints because engagement in terms of MSA is for three to five years. Therefore, the revenue growth of IT companies is no longer contingent on winning large deals. IT companies enter into strategic smaller engagements and then subsequently scale up revenues within their client. 

The lack of large and mega deals in Q3FY22 led to a decline in Total Contract Value on a YoY basis and flattish on a QoQ basis. However, Annual Contract Values are healthy. Deal pipeline is strong and growing across companies. But rising inflation is going to put more focus on cost optimization deals which might cause a decline in short-duration deals. 

Strong recovery in technology spend coupled with low headcount addition in the initial 2-3 quarters of the pandemic led to strong hiring by IT companies in subsequent quarters resulting in a ‘war for IT talent’. LTM attrition increased sharply from lows of 8-10% at the start of the pandemic to 20-24% over the last four quarters. 

Accenture did net addition of record 105K employees in H2CY21 (majority of new hires from India) vs 10K per quarter pre-covid. Net hiring by the top 5 IT firms (TCS, Infy, Wipro, HCLT, and TechM) was 187K in 9MFY22 as against 87k in FY21 and an average of 50-60K per year pre-covid.

The demand environment will remain strong in the medium term, but a massive pressure on margins is expected in H1FY23E, which will again stop earnings upgrade. Inflation in the US has risen to record highs with US CPI Urban consumer index growth of 7.9% YoY in Feb’22 vs 2% average growth in US inflation index for the past 10 years – which will lead to further increase in onsite wage inflation. Talent shortage will continue to put pressure on demand fulfillment in spite of the decadal strong hiring trend last year. Most tailwinds for margins will be backended.