Industry
Why global headwinds will hurt smaller tech firms more
Summary
- Tier-II IT services companies might outpace their larger peers in growth, but they don't enjoy some of the benefits that accrue from size.
Over the past year or so, tier-II IT services companies such as L&T Infotech, Mindtree and Mphasis have grown faster as a group than the top five—Tata Consultancy Services, Infosys, Wipro, HCL Technologies and Tech Mahindra. This has reduced the revenue gap between the two groups. However, beyond this, the tier-II group does not have much to cheer about. Industry growth is slowing and, given the current macroeconomic factors, could slack off further.
Demand for IT services tends to slow down when key client sectors are under strain. In the recent past, several sectors that traditionally outsource technology services to Indian IT firms have signalled caution. US banks, for example, are projected to report a drop in September-quarter profits due to inflation and fewer investment-banking opportunities. In Europe, there are concerns around Credit Suisse and Deutsche Bank. The BFSI sector (banking, financial services and insurance) accounts for about 30% of Indian IT revenues.
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The business environment is difficult, as TCS CEO Rajesh Gopinathan acknowledged last week. In July, Gartner marked down its growth estimates of global IT spending for both 2022 and 2023.
Tier-II companies might outpace their larger rivals due to lower base, but they won't enjoy some of the benefits that accrue from size. Larger firms tend to be more diversified and have more options to generate new business from existing clients. They also tend to have a greater financial cushion and capacity to manage resources. These advantages show up in margins, attrition and productivity.
Financial cushion
In the last few quarters, Indian IT services companies have been facing a decline in EBIT (earnings before interest and tax) margin, a key measure of profitability. Tier-I companies saw their EBIT margin reduce by an average of 1.7 percentage points in the June-ended quarter on a sequential basis, while tier-II companies saw a fall of around 1.1 percentage points, according to ICICI Securities. (Not all companies in the analysis have reported September-quarter earnings yet.) However, tier-I companies have a bigger cushion. Even after the drop, the top five IT companies have a 5-percentage-point EBIT margin advantage over tier-II companies.
Both sets faced similar pressures on margins. They aggressively hired freshers in 2021-22, lowering utilization rates. Infosys’ utilization rate dropped to 84.7% in Q1, from 88.5% a year ago. Mindtree’s dropped to 81.1% from 83.2%. Both groups handed out pay hikes, which impacted margins to varying degrees.
Attrition pains
High attrition has increased the pressure on margins. When employees leave, companies face continuity issues, as well as higher costs towards hiring, onboarding and training new employees. IT services companies have been facing high attrition rates: at Infosys, for instance, it has topped 20% for five successive quarters. While it dropped by 1.3 percentage points in the September quarter, Infosys CFO Nilanjan Roy said it continued to exert pressure on its cost structure.
On average, attrition rates for the top five IT companies jumped to 23.4% in the June quarter, as compared to 13% a year ago. For tier-II companies, it has been worse, with attrition jumping to 25.1%, from 16.1%, during the same quarters. Meanwhile, IT companies have also made record recruitments: TCS added about 117,000 employees in the last five quarters and Infosys about 75,000 employees. This movement of talent hit tier-II companies harder.
Productivity lever
In the last two years, the differential in employee productivity—measured as revenues per employee—between tier-I and tier-II companies has widened. This metric has declined for both sets of companies in the past two years. For example, for TCS, revenue per employee dropped from $49,300 in 2018-19 to $43,400 in 2021-22. For the top five, it dropped 8%, from $50,780 to $46,680.
However, for tier-II companies, which have traditionally trailed the tier-I set, the drop has been steeper—of 12%, from $49,100 to $43,025. Mindtree saw revenue per employee drop from $49,600 in 2018-19 to $40,200 in 2021-22. Larger companies tend to have a more diverse mix of projects by size and sector, allowing them to use their employees more efficiently. Smaller companies don't have that luxury. When overall demand slows, these disadvantages add up.
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