During the 4QFY22 result season, stocks of IT services companies plummeted due to managements’ comments on probable medium-term margin pressures. IT stocks have been in a slump since then and have been struggling to show some signs of reversal. How does one navigate through this sector?
Demand prospects for Digital and Cloud Services:
Digital services comprise of service and solution offerings of an IT company that enable clients to transform their businesses. These include offerings that enhance customer experience, leverage AI-based analytics, and big data, engineer digital products and IoT, modernize legacy technology systems, migrate to cloud applications and implement advanced cybersecurity systems. Most firms are transitioning through IT and cloud-based solutions to meet competition and cut costs. Global lockdowns and work from home (WFH) culture have accelerated the expansion of digital services.
The BFSI sector is the largest contributor to the revenues of many IT companies. Enterprise clients in the Financial Services sector have ramped up tech spending to enhance customer experience, digitize core systems, and leverage technology to strengthen risks and controls.
Source: Company quarterly update
Cloud migration has picked up pace in the last 3 years. The recent global lockdowns and WFH culture led by Covid-19 have acted as a trigger to accelerate this journey. Enterprise clients are looking to migrate to cloud-based operations, which act as a business continuity tool in times of uncertainty. The shift to hybrid working models has contributed to the demand for IT services. Cloud transformation helps clients deploy streamlined operational efficiencies, increased adaptability and scalability, data security, and cost management.
The IT industry has been facing certain structural headwinds such as:
Attrition levels: Voluntary attrition is when employees leave an organization for better prospects in the industry. With a robust demand environment, IT services organizations have seen higher attrition, resulting in supply-side constraints since 2QFY22. These challenges are expected to put pressure on margins over the medium term. IT companies are taking measures to stabilize attrition levels by correcting compensations, faster career growth, skill development programs, and greater engagement with employees.
Source: Company quarterly update
Subcontracting costs: Subcontracting is the process of outsourcing partial obligations of a contract. Due to tight labor market conditions and the non-availability of talent in-house, IT firms have turned to subcontractors. Rising subcontracting costs have brought margins under pressure. Reduced dependency on these services through increased hiring programs and stabilization of attrition levels can subside margin pressures.
Higher retention, hiring costs, and travel costs: Wage increments, employee retention costs, and accelerated hiring are some of the key factors that could drive margin pressures. With the reopening of economies, we expect travel costs to normalize over the medium term.
While the above-mentioned factors are expected to take a hit on the profitability of IT services companies, we expect demand prospects to be robust with digital transformation and cloud migration being a key area of focus for enterprise clients. We expect margin pressures to persist over the medium term.
Should one invest now?
We believe the favorable long-term outlook remains intact, driven by enterprise client demand for cloud and automation, improved utilization levels, as well as the normalization of inflationary pressures. Increased costs due to supply challenges are likely to be transient. This may be the right time for investors with a longer time frame for investing to look at the sector.
Disclaimer: “The views expressed are for information purposes only. The information provided herein should not be considered as investment advice or research recommendation. The users should rely on their own research and analysis and should consult their own investment advisors to determine the merit, risks, and suitability of the information provided.”