Sub-contracting takes a toll on tech leaders
Premium- On an aggregate basis, Ebit margins of large technology firms fell from 22% in Q2, to 21.7% in Q3
- TCS has said its subcontractor expenses, which used to be about 7.5%, are now 9%
For investors in stocks of tier-I IT companies, elevated subcontracting costs have been a sore point in recent quarters. This is one reason margins of these companies shrank in the December quarter (Q3FY22), while their mid-cap peers saw an expansion. On an aggregate basis, Ebit margins of large technology companies fell from 22% in Q2, to 21.7% in Q3, showed an analysis by Motilal Oswal Financial Services Ltd. Ebit is short for earnings before interest and taxes.
Investors in IT stocks are well aware of the talent crunch and high attrition in the sector. Since demand has been strong, with robust deal wins, companies have not been able to fulfil client requirements using existing resources. For instance, in a post-Q3-earnings conference call, the management of Tata Consultancy Services said the company’s subcontractor expenses, which used to be about 7.5%, are now 9%. The management said it expects this higher cost to remain till employee churn stays elevated. In the case of Infosys, subcontractor costs increased to about 11% of sales, the management said.
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While subcontracting costs may remain higher in the near term, it will start easing as soon as the pace of fresher hiring picks up. It should be noted that when more employees join a company at the lower end of the pyramid i.e. freshers, it reduces costs, aiding margins.
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“The subcontracting expenses have been higher for large IT companies compared with some of their tier-II peers. We think that for the industry, subcontracting costs have likely peaked and should start coming down in the next few quarters. The aggressive hiring that IT companies have done in the recent quarters should result in the need for subcontractors coming down," said Kumar Rakesh, senior automobile and technology analyst at BNP Paribas India.
Concurring, Rishi Jhunjhunwala, senior vice-president and lead analyst, technology, at IIFL Institutional Equities Ltd said, “Subcontracting costs are already elevated and may remain so in Q4. However, it should start coming off in FY23 as fresher hires replace them over the next few quarters."
In the December quarter earnings call, the TCS management said that it has on-boarded 34,000 freshers on a year-to-date basis in FY22 and will add more in the March quarter. Peer Infosys has raised its fresher hiring target for FY22 to 55,000 from 45,000 earlier.
But that’s not all. There are other levers that would buoy margins of large technology firms. Their management commentaries point to high attrition pressures easing in the coming quarters. Also, IT companies have taken price hikes. “Our channel checks indicate 4–7% price hikes in digital contracts, so even that would aid margins in coming quarters," added Rakesh. Further, analysts point out that the headwinds to margins from higher salaries, promotions and retention packages are largely behind.
Meanwhile, the stocks of TCS, Infosys, and Wipro are trading at price-to-earnings multiples of 28 times, 26 times, and 21 times, respectively, based on the earnings estimates for FY23, showed Bloomberg data. The FY23 P-E of midcaps L&T Infotech Ltd, L&T Technology Services Ltd, Mindtree Ltd is in the range of 32–38 times. The valuation gap between large-cap and mid-cap IT stocks is attributed to the higher earnings growth and better margins of the latter. Little wonder then that in the last one year, tier-II IT stocks have comfortably beaten larger competitors and the Nifty IT index.
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