American recession will come in Bangalore too

The Bengaluru-based firm, which reported its June quarter earnings on Sunday, is considered the industry’s weathervane. If it’s optimistic about orders, there’s reason to believe the deal pipeline isn’t drying up. US and European firms – from banking, manufacturing and retail to health care and utilities – are still entering into offshoring contracts, especially those that will help them automate processes to cut costs.

According to Knight Frank, the 12% year-on-year jump in Bengaluru office rents from the previous quarter also shows evidence of increased activity – three times as many as Shanghai, Singapore or Sydney. In the code-writing capital of the world, information technology operates more than two-fifths of office-space leases. If tenants are paying more for the location, they should be excited about the future.

But is this optimism well-founded? Take a closer look at the financial results of IT firms, and you will see signs of declining profits. Infosys managed to post just over 3% in rupee earnings compared to the June quarter a year ago, even with nearly 24% revenue growth. A 20% EBIT margin — earnings before interest and tax as a percentage of revenue — is a decline of 3.6 percent year over year. In fact, it’s even worse than what the Belvedere outsourcing firm was achieving just before the pandemic gave the business a big lift.

Infosys’ traditional Bengaluru rival, Wipro Ltd., EBIT margin fell to its lowest level since the September 2018 quarter. Partly that was because it contracted more than 15,000 net new employees, including 10,000 new graduates, in the three months to June 30. (During the same period Infosys increased its workforce by more than 20,000.) But then, competitor HCL Technologies Ltd. , which reduced quarterly net hiring by about four-fifths to nearly 2,000, also saw lower-than-expected EBIT margins of 17%, a multi-year low.

The largest Indian IT vendor Tata Consultancy Services Ltd’s margin was better at 23.1%, but it was still 2.4 percentage points lower than the June quarter of 2021. TCS Management has indicated that quarterly deal wins valued at $7 billion to $9 billion may be a sustainable rate. Nomura says it’s “flatish” based on year-over-year growth.

Profitability could remain under pressure for the rest of this year – both because of the slowdown in the West, and the way the industry is structured in India. Offshoring is profitable, but the people employed by it will not stay at their jobs forever without posting onsite at client locations and dollar pay. With the pandemic over, travel and visa expenses are on the rise. But Indian sellers will struggle to get paid more – customers will cite a nearly 7% depreciation in the rupee this year as a reason not to raise the dollar value of the contracts. However, the exchange rate advantage will be insufficient to meet the rising cost pressure of the rupee.

For one thing, the wage increase can’t be overstated: TCS employs more than 600,000 people, but its casualty rate is touching nearly 20%, more than double what it was a year ago. Employee retention appears to be even more challenging at Infosys, where the workforce grew over 28% in the June quarter. Startups that target India’s local e-commerce or fintech markets compete for programmers, similar to software exporters. While smaller, private-equity-funded firms are becoming cautious about burning cash on payroll, an employer market for coding talent is probably a story for the next year. With India’s domestic inflation rate of 7%, IT services firms have little room to tighten the belt on wage costs.

Ultimately, they will all resort to “pyramiding” to protect their margins. It basically means putting a lot of inexperienced code-writers under an experienced project manager and hoping that the client will still be happy. But since rookie productivity has its limits, more complex programming will have to be sub-contracted to smaller vendors. The cost of doing so is also increasing.

The best bet for India’s IT services exporters is to hope that the US economy – their most important market – will survive the recession; And that customers who have increased their digital budgets during COVID-19 will continue to place orders. Will they? Customers may continue to see value in cloud computing, analytics, artificial intelligence, and even augmented reality, but their “willingness to spend is their ability-to-spend” because of “commodity and wage inflation, supply-to-earnings pressure”. capacity would be hindered”. Mumbai-based broker Nirmal Bang Securities says that chain challenges, low consumer spending power, high interest rates and downward trend growth in western developed economies are likely.

Large consumer tech companies like Alphabet Inc. or Meta Platforms Inc. are seeing their premium valuations drop. The more industrial end – writing code for Western corporate customers – also wouldn’t be immune. India’s Nifty IT index, which has tripled between the onset of COVID-19 in March 2020 and the end of last year, has slipped 27% so far in 2022. Investors aren’t as optimistic about profitability as Gung-Ho books about software exporter orders. Sooner or later the US recession will come in Bangalore as well.

Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia. Prior to this, he worked for Reuters, Straits Times and Bloomberg News.

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