Why global adversities will hurt Tier-II IT companies more

When key customer segments are under pressure, demand for IT services slows down. In recent times, several sectors that have traditionally outsourced technology services to Indian IT firms have indicated caution. For example, US banks are projected to report a decline in September-quarter profits due to inflation and lower investment-banking opportunities. In Europe, there are concerns about Credit Suisse and Deutsche Bank. The BFSI sector (banking, financial services and insurance) accounts for about 30% of Indian IT revenue.

The business environment is tough, as TCS CEO Rajesh Gopinathan admitted last week. In July, Gartner marked its growth projections for global IT spending for both 2022 and 2023.

Tier-II companies may outshine their larger rivals due to a lower base, but they will not be able to enjoy some of the benefits that come from size. Larger firms are more diversified and have more options to generate new business from existing customers. They also have more financial cushion and capacity to manage the resources. These advantages are reflected in margins, attrition and productivity.

financial cushion

Over the past few quarters, Indian IT services companies have been facing a decline in EBIT (earnings before interest and tax) margins, a key measure of profitability. According to ICICI Securities, Tier-I companies saw their EBIT margins decrease by an average of 1.7 per cent on a sequential basis in the June-ended quarter, while Tier-II companies saw a decline of around 1.1 per cent. (Not all companies included in the analysis have yet reported September-quarter earnings.) Tier-I companies, however, have a bigger cushion. Even after the decline, the top five IT companies have a 5-percentage-point EBIT margin advantage compared to Tier-II companies.

Both the sets faced equal pressure on the margins. They aggressively hired freshers in 2021-22 while reducing utilization rates. Infosys’ utilization rate declined to 84.7% in the first quarter, from 88.5% a year ago. Mindtree fell from 83.2% to 81.1%. Both groups gave pay increases, which affected margins to varying degrees.

attrition pain

High attrition has put pressure on margins. When employees leave, companies face continuity issues, as well as higher costs for hiring, onboarding and training new employees. IT services companies are facing high attrition rates: for example, in Infosys, it has been above 20% for five consecutive quarters. It declined 1.3 per cent in the September quarter, but Infosys CFO Nilanjan Roy said it continued to put pressure on its cost structure.

The average attrition rate for the top five IT companies rose to 23.4% in the June quarter, from 13% a year ago. For Tier-II companies, it has been worse, with a jump of 25.1%, from 16.1% during the same quarters. Meanwhile, IT companies also posted record hiring: TCS added around 117,000 employees and Infosys added around 75,000 in the last five quarters. This movement of talent gave a tough competition to Tier-II companies.

productivity lever

Over the past two years, the gap in employee productivity – measured as revenue per employee – has widened between Tier-I and Tier-II companies. This metric has declined over the past two years for both sets of companies. For example, for TCS, revenue per employee fell from $49,300 in 2018-19 to $43,400 in 2021-22. For the top five, it fell 8% from $50,780 to $46,680.

However, for Tier-II companies, which traditionally lag behind the Tier-I set, the decline is 12%, from $49,100 to $43,025. Mindtree’s revenue per employee fell from $49,600 in 2018-19 to $40,200 in 2021-22. Larger companies have a more diverse mix of projects by size and region, allowing them to use their employees more efficiently. Smaller companies don’t have that luxury. When aggregate demand slows, these losses increase.

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