Indian IT services in 2023 | The Financial Express

Clipped from: https://www.financialexpress.com/opinion/indian-it-services-in-2023/2950212/

After the surge in hiring during the pandemic years, 2023 could bring in a trend reversal for the IT sector

Indian IT services in 2023he IT sector’s valuations are still at a 13% premium to the broader market despite the 26% YTD correction and this over-valuation remains a key hurdle for investors. (IE)

As we all now know, during the pandemic, corporations the world over accelerated their ‘digital first’ efforts. As a result, Big Tech firms such as Facebook and Google, as well IT services firms in our backyard—both TWITCH (the six largest TCS, Wipro, Infosys, TechMahindra, Cognizant and HCL) as well as the next level such as L&T-Mindtree—upped their hiring operations to meet this ‘once in a lifetime’ surge in demand in 2020 and 2021.

But 2022 was a journey from an all-time high in demand to an environment of fear leading to the IT sector underperforming the Nifty index by 26%. So, what will happen this year? Will the cycle turn again to one of high growth? The sector has begun to post results and is roundly expected to post a soft quarter, impacted by both the global Christmas slowdown and a worsening macro environment. Most equity analysts seem to expect sees revenue growth decelerating from an estimated circa 13% in fiscal 2022-23 to circa 8% or less in fiscal 2023-24 and the year after that.

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But other (non-equity) industry analysts such as ISG Inc., (the firm I used to work for) and Gartner, have lead indicators that seem to imply a moderation and not a pullback in IT spend, according to Pankaj Kapoor and Rucha Somaiya of CLSA, an equity research house. According to them, steady but moderating deal activity, as reported by ISG Inc., and continued market share gains could help lessen the impact for the Indian IT services companies.

They posit that there could be a trend reversal in calendar 2023. Their argument hinges around the fact that the Nifty IT Index has underperformed the Nifty for successive years only once in the last fifteen years and therefore a ‘tapering of fears’ could bring the investors’ interest back in the sector. They are careful, however, to say that the upside may be capped since the sector’s valuations remain at a premium to the broader market. The IT sector’s valuations are still at a 13% premium to the broader market despite the 26% YTD correction and this over-valuation remains a key hurdle for investors.

There is also an expectation across equity analysts who cover the sector that there is a lot of headroom for profit margin uplift. Most of this headroom on margins comes from the fact that IT service companies are now beginning to trim excesses by cutting down on variable pay and by insisting that their workers start making the old trek to the office.

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Most importantly, these firms will now put in place the tried and tested method of ‘pyramid rationalisation’, which is industry-speak for hiring young fresh graduates to replace overpaid mid-level staff. In fact, the industry pumped up its campus hiring levels significantly during last fiscal—to more than double in some cases (for instance, TCS hired 100,000 fresh graduates in fiscal 2021-2022 versus 40,000 the preceding year. At Infosys, the corresponding numbers were 85,000 versus 21,000 per company reports). The sector continues to keep its campus hiring levels high, though these may moderate somewhat over the next few years. This massive influx of fresh graduates will be key to the shedding mid-level bloat in salary costs caused by frenzied hiring of programmers with 3-8 years’ experience during the pandemic. They will simply replace their overpaid seniors—at much lower salary costs.

Separately, there are reports that inflation may be cooling in the US, and as a result, the Fed’s interventions will reach a logical end-point. As a result, some economists now expect the dollar to come off its recent highs, thereby providing a currency lift to the IT sector—not so much as a result of operating efficiencies, but as a result of hedging operations put in place by these firms during the time at which the dollar was expected to continue to rise.

Interestingly, despite the circa 8% growth expectation for this year and next year (versus circa 13% last year), many downstream IT services are in fact positively impacted as macro headwinds cause increased scrutiny by clients of the utilisation of existing assets such as their ‘hyperscaler’ cloud consumption licenses and software-as-a-service subscriptions. Simply stated, it costs money in services to save money in computing and software infrastructure.

Some of the now softer commentary around demand deterioration also comes from the fact that consensus forecasts for 2023 revenue growth for a basket of 60 global client firms (among the top 20 clients of the top six Indian IT services companies) is still higher versus previous downturns. Also, contract staffing revenue of many IT sub-contractor firms continue to grow above pre-pandemic levels per CLSA, indicating that though services demand has moderated, it has not fallen off a cliff.

In addition, the analysts report that India-listed companies expanded their revenue market share by about 2.8 percentage points over the last 11 quarters since the start of the pandemic. This, to me, is the most stunning figure, driven possibly by remote work becoming the norm during Covid. In some ways, Covid provided an acceleration to the offshore engines of these firms, which first fired up around the dotcom bust of twenty years ago. The extended lockdowns and forced ‘remote work’ have caused a broader acceptance now that certain types of work can be done anywhere around the globe. For these types of work, working from your home in Bengaluru isn’t that different than working from your home in Boston. Let’s see what this new year brings.

The writer is technology consultant and venture capitalist

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