IT firms have to solve high wage cost problem to sustain in uncertain times

After a period of hyper-growth, slowdown fears in key markets including the US and Europe are making the Indian IT industry jittery over growth prospects in coming quarters. Operating margin is also under significant pressure owing high wage cost amid elevated employee attrition.

In a conversation with Bizz Buzz, IT industry veteran and Founder & Managing Partner of Siana Capital Management Siddharth Pai said that IT industry has significantly raised salaries of mid-level staffers during the pandemic, impacting the cost structure. Therefore, IT firms have to take up various cost optimisation measures including the wage cost to sustain in an uncertain demand environment.

What are your views on the current demand environment for the IT industry? How do you see the margin pressure faced by most IT firms? How IT firms will be able to address these challenges?

The potential problem is that companies are thinking what will be recessionary impact on demand. Given that there was quantitative easing, now the US Federal Reserve is tightening up. The central banks are increasing the interest rates. As interest rates go up, that can impact client's bottom line. But this is still an unknown because how various factors will paly out that is not known. Also, there is very strong employment data coming out of the United States. It's not that jobs are not being created. So, nobody knows up to what level recessionary impact will be there though there will be recessionary impact up to certain level. So, on one hand, companies don't know how the demand environment will look like, though the demand environment is getting weaker as of now.

There is no doubt about it. But there is no certainty about by how much the demand is going to be weaker and how soon. So, that is the uncertain problem. The certain problem is in many ways created by the Indian IT companies themselves. During the course of the pandemic, the amount of demand for people, especially in the 3-6 years of experience bracket and also 6-10 years of experience; has gone up substantially. In order to meet the demand, what these people did was, they went ahead and increased the salaries very significantly. In some cases, salaries were doubled. It's not a sensible thing to do.

If today, somebody is worth Rs 6 lakh, and the company will pay him Rs 12 lakh (to meet the demand), tomorrow the client will not pay the company because that much demand is not there. Now, these companies are stuck with very high-cost resources who can't do the billing that the firms are expecting. So, what will these companies do? They may let them go.

The mistake that was done was during the uncertainty of Covid, companies went ahead and made decisions of increasing the salaries. In the past, these IT firms managed it pretty well. What they did was they put barriers to exits. Things like three months relieving time, and other such parameters were imposed.

These initiatives were supported by industry bodies like Nasscom. However, these were not followed. These companies were poaching resources from one another. So, all those people who have seen substantial increase in their salaries are going to see their variable pay being cut and no salary hikes among others. Meanwhile, what is happening is that fresher salaries have not increased. It remains at those levels of Rs 3 lakh or bit higher. That has not changed for a long time.

So, companies will train these people and replace high-cost resources with these freshers. Even if they deploy two freshers for one experienced people, companies will still pay less. So, what is certain is that the industry made a mistake by bidding up the salaries for the people in the middle-experienced bands. Therefore, most of the pain is going to be experienced by people in the middle-experience band. So, as companies reduce cost, laying off of these resources can't be ruled out. This is bubble and like all bubbles, it has to burst and now the bubble is bursting.

We have seen margin pressure building up for all IT companies. Do you feel such pressure to continue in coming quarters?

All companies have witnessed a margin squeeze. Now, market participants like analysts are asking questions. So, companies are in a bind. Market continues to be hot. Now, these companies have to decide to drive the air out of the labour market. Many brokerage firms are reducing their price targets for these IT firms. The sector is facing structural problem and there is no doubt about it.

So, can we expect that IT firms will adopt more automation as part of cost optimisation lever?

Automation is a secular trend. That is there for a long time and that will continue. There are also other cost levers that companies will apply. For example, things like unnecessary travel, and rental cost among others will be reduced. Also, work from home (WFH) is not going to work as this reduces productivity significantly. When global technology giants like Google is asking people to come back to office, what we are talking about on productivity.

Subcontractor cost has gone up for most large IT companies. From a pre-pandemic level of 5-6 per cent, it now touched about 11-12 per cent for most players barring a few exceptions. What are your views on this rising subcontracting cost seen in the industry? Do you feel that IT firms will consciously try to increase the offshoring pie further in coming quarters to support margins?

It is natural that as a result of what happened, some portion of work will move to cloud and will necessarily move to cloud work-floor places. People with extremely high skill will get out of the system and deliver services to IT firms. Therefore, the subcontractor piece will increase. This is not necessarily good news because these subcons can provide their services sitting anywhere in the world. So, engineers from Eastern Europe or any other places can give these services.

Of course, IT firms will try to reduce the subcon costs. Offshoring as component will depend on the type of projects that is under implementation. And beyond a point, it is difficult to increase offshoring. Also, if companies will go beyond the cap, efficiency and productivity will be hurt. For several years, companies are pushing up that level. But there is a limit. Secondly, what is the point of pushing the offshoring levels when companies are paying very high salaries to engineers who are working here in India.

A record number of freshers have been onboarded in the last one and half years. Will companies actively manage employee pyramid to keep costs under control?

Yes, that will happen. Companies will try to replace freshers with mid-level engineers. Secondly, wage cost has not changed much for fresh engineering graduates in the last two decades. Companies will definitely use this lever. The only question is how much the clients will allow to use this lever.

Because that also comes with productivity problem. So, companies will get margin support as they reduce cost through many levers. But the current problem is going to continue for next few quarters because this can't be solved in a short period of time. Three-quarters will be the time period that companies will take to take the cost out of the system.