Indian IT moving toward cost rationalisation, mega deals, hiring slowdown

The Indian IT services industry is regrouping itself, and its contours for the future reveal three key trends – a shift towards aggressive cost rationalisation, the rise of mega deals as a growth driver, and the persistent weakness in discretionary spending (non-essential investments).

However, the collateral fallout of this trend translates into fewer campus placements and a contraction in the IT workforce. In the case of one of the market-leading IT services companies, Infosys, the headcount for the second quarter (July-Sept, 2023) was 3,28,764 employees, which was lesser by 7,530 on a quarter-to-quarter (QoQ) basis. The net reduction for the last nine months was around 18,000 employees.

The company has said that while hiring 50,000 freshers in FY23, it will miss the campuses in FY24 as it has a substantial bench of freshers. Attrition for 2QFY24 came in at 14.6 per cent and was lower by 270 basis points (1 basis point equals 0.01 per cent) on a QoQ basis. What is significant to know is that it was the weakest in the last nine quarters and lower by 1,250 basis points on a year-on-year basis.

However, some analysts read the reduction in hiring differently. “The focus is on redeploying existing talent wherever projects are available, given the headwind from delays and pauses in certain projects/programmes. Do note that some of the mega-deals have a rebadging element and may have higher usage of subcontractors during the initial ramp-up period, which will also reduce the need for fresh hiring of delivery personnel,” Kotak Institutional Equities said in its report to investors.

Cost rationalisation

One of the standout conclusions from these earnings reports is that companies have finally taken decisive action in pursuing aggressive cost rationalisation. This represents a significant departure from their stance earlier in the year when they seemed content carrying inefficiencies in the hope of a back-ended growth recovery.

The initial optimism for a quick rebound did not materialise, prompting companies to align their costs more closely with actual demand. Various measures have facilitated this shift, including raising utilisation rates, increasing productivity, lowering the average cost of resources, further trimming subcontractor expenses, and managing SG&A (selling, general and administrative) costs.

Some analysts believe that the sector is still in the woods. “We continue to be cautious even now as we believe the worst on the macro front is ahead of us and not behind us. We recently cut FY25 revenue/earnings for the entire sector as we believe our base case of a shallow US recession is pushed back into 2024,” broking firm Nirmal Bang said.

Lower revenue

For Q2FY24, Infosys gave lower revenue guidance at 1 per cent to 3.5 per cent from 4 per cent to 7 per cent because of the delay in decision-making. Wipro, too, lowered its revenue guidance for the December quarter from -3.5 per cent to -1.5 per cent, indicating a further slowdown in revenue growth. “The reasons for weak guidance are broadly in line with what its peers have indicated – volume compression in the base business, cutting of discretionary spending and late start dates on new projects won,” Kotak said.

For IT services companies, a notable opportunity lies in reducing the average cost of resources, primarily as many tech firms engaged in a hiring spree during the COVID-19 pandemic, resulting in lateral hires with inflated salaries. Gradual corrections through differential merit increases can mitigate this issue.

Overall, companies have a range of levers to improve margins in the medium term, with margin expansion forecasts of 60-110 bps over FY2024-26E for TCS, Infosys and HCLT. However, it is essential to remain vigilant about the potential risks, including unforeseen demand deterioration and the costs associated with returning to the office.

Mega deals

The second major takeaway revolves around mega deals' prominence in these companies' portfolios. TCS, Infosys and HCLT recorded record-high Total Contract Value (TCV) deal wins, primarily driven by their clients' pursuit of cost optimisation initiatives.

These mega deals are crucial in revenue growth, mainly as FY2024 saw subdued growth due to weak discretionary demand and a lack of momentum from mega deals.

The prospect of significant cost-cutting deals remains positive, supported by a strong pipeline despite high Total Contract Value (TCV) conversions. These deals are typical in challenging circumstances and offer extended durations, helping vendors offset initial investments, especially when involving workforce transition (rebadging). The capability to provide comprehensive multi-service solutions gives the industry's top three players a competitive edge.

Discretionary spending

The third theme centres on the ongoing challenges in discretionary spending. Cancellations, delays and reprioritisation continue to hinder this spending category, a trend that started in the March 2023 quarter and persists today. The expectation that the pace of discretionary spending pullback would moderate has yet to materialise, posing a significant challenge to meet revenue growth estimates of 8 per cent-10 per cent in constant currency for FY2025.

Signs of stabilisation and an uptick in discretionary spending are eagerly awaited and may become visible by the first quarter of the 2024 calendar year. “Cancellations, delays and reprioritisation continue to impact discretionary spending. These challenges that started emanating in the March 2023 quarter continue even now,” Kotak Institutional Equities said.

The Indian IT services industry is navigating a changing landscape with evolving trends and challenges. Adaptability and strategic agility will be essential for companies to thrive in this dynamic environment.