Tough times ahead for Indian IT sector

Globally, concerns relating to macroeconomic stability are showing no signs of receding. Rather, commentary from Europe indicates what is in store. The continent is facing its worst drought in several decades. Aggravating the situation, Russia-Ukraine war is intensifying each passing day. The reliance of Russian oil & gas supply to most European nations is under question now with Russia shutting major pipeline – Nord Stream 1.

Most developed economies of Europe including Germany, France and United Kingdom are likely to slip to recession towards the end of this year. This is not music to the ears of Indian IT industry. Europe constitutes around 30 per cent of revenue of large IT services players. Some companies also have large exposure to UK as a geography. Though mid-tier IT firms' exposure to Europe is lesser as compared to large counterparts, overall slowdown in Europe may spell trouble for IT spending. When companies' earnings get affected, they are bound to tighten the belt across spectrum and technology spending may not escape the larger trend. One silver lining is emergence of large cost takeout deals.

But certainty and predictability are less in those kinds of deals. Meanwhile, inflation concerns are prompting US Federal Reserve to raise interest rates. Though key indicator like employment data remains positive in the US, hiring freeze and even layoffs in technology giants don't inspire confidence. Amid such an environment, Indian IT firms are facing margin squeeze owing to wage cost pressure and rising travel & utility expenses.

As Indian IT players navigate the unknown, stock markets are also reflecting the valuation concerns. Most IT firms' valuations have taken a beating of more than 30 per cent since the beginning of this year. Nifty IT index is an underperformer in the first eight months of this year. Despite share prices showing some signs of revival, market participants are worried about the secular trend of margin decline in the last two years.

Many expect margins in FY23 to be lower than the pre-pandemic period. If this decline proves to be structural, then companies will face de-rating by brokerage firms. Against this backdrop, Indian IT industry is likely to take many tough decisions in coming quarters. Experts say domestic software services companies had successfully navigated such situation before. Indian IT industry is known for its resilience.

Therefore, despite a not-so conducive environment, IT firms will be able to sustain growth curve in coming quarters. Currently, the management commentary of large and mid-tier IT firms indicates cautious optimism. As these companies announce their second quarter earnings from October first week onwards, investors will keenly listen to their comments on demand and deal flow to gauge the overall environment.

Amid all these events, there are also some positive factors supporting the IT industry. For instance, IT companies are expected to get some respite from high employee attrition level as hiring momentum across technology industry loses steam. Also, rupee fall against dollar is likely to support both earnings and operating margin. Second quarter earnings, therefore, will be crucial for future direction.