The quarterly earnings season for the IT sector has kicked off on a mixed note, with TCS reporting inline results and Infosys missing estimates on revenue, margins and earnings. However despite the March quarter miss, Infosys closed the year on a strong note with its highest revenue growth in the last decade and comfortably outpacing TCS.
Outlook commentary from both companies and strong revenue guidance from Infosys, in particular, indicates demand remains strong and the sector appears be shielded so far from any negative impact to business from the Russia-Ukraine crisis. Nevertheless it bears watching whether the impact can play out with a lag effect, which can be ascertained after a couple of quarters.
However what bears immediate attention is the complete lack of operating leverage despite the strong revenue growth reported by these companies. Ideally operating leverage should kick in with revenue growth as companies benefit from fixed costs optimization, especially when revenue growth is the best it has been in a decade. That has not been the case, with variable costs increasing at a higher rate than that of revenue, to the extent, that it denies the scope for operating leverage. For example in the case of Infosys, its cost of sales (primarily employee and subcontracting costs) increased by around 25.4 per cent versus revenue growth of around 21.1 per cent. Thus its gross margins for FY22 was lower at 32.5 per cent versus 34.9 per cent in FY21. With no benefit of operating leverage, operating margin for FY22 at 23 per cent was lower than 24.5 per cent reported in FY21. Despite revenue expected to grow a solid 13-15 per cent (in constant currency) in FY23 as per management guidance, operating margin may dip further and has been guided at 21-23 per cent.
So too is the case with TCS, which despite delivering revenue growth of 16.8 per cent in FY22, has seen operating margin dip to 25.3 per cent versus 25.9 per cent in FY21. Strong business demand resulting in higher demand for talent to capture the business opportunity, has resulted in higher than expected wage inflation and high churn which further escalates costs.
The law of diminishing marginal utility states that all else equal, as consumption increases, the marginal utility derived from each additional unit declines. Something similar to this is what appears to be playing out in the IT sector, with each unit of growth coming in with lower marginal utility (ie lower margins). How this evolves would be interesting to watch. For now it does appear gunning for growth is the right thing to do, despite relatively lower utility, as it is still adding value.