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While demand tailwinds are making sure that the top-line IT companies grow at a much faster rate, even on a larger base, it is the attrition rate that is turning out to be a pain point. This is not the first time that attrition rates have gone up. But the way it affects the margins is very different for each company.The IT services industry has entered into a technology upcycle, with cloud migration and digital transformation-led deals coming to the market. Digital transformation and cloud-native have resulted in substantial demand across service lines and verticals in various geographies. Covid has undoubtedly aided the digital revolution. As TCS CEO Rajesh Gopinathan said, only 20-30 per cent of businesses have completed digital transformations thus far, indicating that this demand would be sustained at least in the long term. The search for human resources has accelerated as a result of this need. This has sparked a talent war among IT companies, resulting in high attrition rates across the industry. Also, recently, IT employee union Nascent Information Technology Employees Senate (NITES) has filed a complaint with the Labour Ministry against Infosys seeking the removal of a non-compete clause that bans employees who resign and join a rival company from working for the same customer they were servicing at Infosys. This makes it evident that companies are indeed feeling the heat of attrition.We will see how this problem is affecting the IT sector by analysing the results of two large-caps (Tata Consultancy Services, Infosys) and two mid-cap companies (Larsen and Toubro Infotech, Mindtree). Financials 91173987As of Date: Mar 2022Source: Ace AnalyserWe can see that revenue growth was affected in Q1FY21 due to the uncertainties associated with the pandemic. But after that short hiccup, the pandemic accelerated demand for technology investment. This led to good growth across the quarter for all the companies. Deal wins confirm this trend. 91174003As of Date: Mar 2022Source: Ace Analyser 91174022As of Date: Mar 2022Source: Company FilingsEBITDA margins are also steadily rising after Q1FY21 due to robust demand. The margins reached its peak for all the companies around Q3 FY21-Q4 FY21. Thereafter, due to sustained high demand for technology spending by clients, IT companies had to invest in talent. Human resources are the primary asset of these companies. As demand from clients increased, the demand for human resources began to rise. This led to high attrition. Employee attrition rate is the percentage of employees who leave a company in a specific period. IT companies report attrition on an LTM (last 12 months) basis. Because many IT companies had not invested in talent management in the years leading up to the epidemic, due to low demand, the sector was unable to cope with the situation. As a result, from Q3FY21 to Q4FY21, attrition began to impair these firms’ profitability. The attrition rate is now the highest in Q4FY22 against the previous quarters. Although, it has started normalising for the companies on a quarter-to-quarter basis. The management of the IT companies have indicated that the attrition rate would continue to have its impact for a few quarters and then the situation would normalise.In order to counter the high number of resignations, companies have started to hire experienced professionals and freshers by giving them higher salaries, employee stock ownership (ESOPs) and other perks and benefits. A lot of freshers are being hired.Company Name Current Employee Strength% YoY Increase in EmployeesTarget to Hire in FY23TCS 5,92,19521.2%40,000+Infosys3,14,01521%50,000+LTI46,64829.6%6,500+Mindtree35,07147.2%40-50% more fresher hiring against FY22Source: Company FilingsAs of April 2022Deal Wins: Total contract value (TCV) refers to the whole revenue generated from one particular contract (or customer), including one-time charges such as costs related to cancellation or an onboarding fee. It measures how much value a contract is worth once executed. TCS had the highest TCV in Q4FY22, at $11.3 billion. Infosys had a TCV of $2.3 billion in the period. Mindtree notched a TCV of $390 million, against $358 million in Q3FY22. In Q4 FY22, LTI won 4 large deals with net new TCV of over $80 million. The deal pipeline continues to be robust for all the companies. Historical view on the relationship between attrition, EBITDA margins and revenue growth 91174065Source: Company Filings, Ace analyserAs of Date: Mar 2022 91174079Source: Company Filings, Ace AnalyserAs of Date: Mar 2022 91174101Source: Company Filings, Ace AnalyserAs of Date: Mar 2022 91174116Source: Company Filings, Ace AnalyserAs of Date: Mar 2022Note: LTI got listed on the stock exchange in July 2016From the historical data of IT companies, it can be seen that attrition rose in 2010-12 and later got normalised. Between 2010 and 2012, TCS was able to manage the margins as well as attrition despite having good top-line growth. Infosys was not able to manage its attrition level and EBITDA margins. Mindtree had a high attrition of 25% (an all-time high) in FY12 but it was able to recover the margins lost during 2011. It will be interesting to see how these companies fare in the current cycle. Key Enablers: 1) The need for digitalisation, cloud, and digital transformation is real.2) Long-term demand remains robust as we are still in the early phase of the digital journey.3) The demand commentaries of all IT companies have been positive, backed by a robust deal pipeline in the near term.4) Top management of TCS has indicated that technology spending might be the last one to be affected in the case of macro uncertainties. Key Risks: 1) A high attrition rate can affect margins further. 2) Higher inflation can lead to postponement of discretionary technology spending, and focus on cost optimisation can increase. 3) Gartner also has reduced its forecast of IT spending in CY22 to 4% (versus 5.1%) and that of IT services to grow at 6.8% (7.9%).ValuationCompany Name Market Cap(Rs Cr)Current PE Historical Median PE% PremiumTCS 12,71,264332914%Infosys6,57,913302330%LTI96,173422662%Mindtree59,980362544%Source: Ace AnalyserAs on April 19, 2022Note: Historical Median PE is calculated by taking the average of 3, and 5 years’ median PEsConclusion: The IT sector has been the talk of the town since the pandemic began. This led to a huge rise in the stock prices of all the companies in this space — irrespective of whether they are largecaps to smallcaps. The premium valuations commanded by these companies continue to stay — especially in the midcap space — in spite of the recent corrections as demand for technology services remains stable over the long term. Macroeconomic trends can cause certain corrections, but the long-term prospects remain positive for the sector. (The authors, Gaurav Jain & Parimal Ade are Founders, InvestYadnya.in. Views are their own.)Disclaimer: The information here is provided for reference purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell stocks or MF.
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