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India IT Services
Wage inflation concerns in the Indian IT industry
persist; the mid-cap has to run a lot faster to stay still
• Wage inflation concerns still persist in the Indian IT industry. We believe
that annual wage hikes in FY12 is likely to be at least 12-15% (offshore) and
3% (onsite). Offshore wage pressures are likely to remain particularly sticky
in view of (a) high domestic inflation in India and (b) continued attrition in
the industry evident from the Dec-10 results (with the exception of
TCS/Infosys, we note that attrition is still uncomfortably high, particularly
with the mid-caps – some of them such as MindTree and TechMahindra -
reported quarterly annualized attrition exceeding 30% for the Dec-10 quarter).
• The mid-cap is likely to suffer more as a consequence. We have already
seen select mid-caps attempt to counter this through a second-round of wage
hikes for FY11 (KPIT, Persistent Systems, NIIT Tech, Infotech Enterprises).
The adverse margin impact on the mid-cap is twice as that on large-caps for
the same percentage increase in wages (offshore and onsite) (in some cases
more than twice the impact). Given their lower operating margins, the impact
on absolute operating profits is even more adverse.
• Take MindTree (UW) versus Infosys (Neutral) as a case in point. A 12%
offshore wage hike and 3% onsite wage hike translates into a negative 520 bps
impact on MindTree’s margins for FY12 per se (excluding traditional levers
such as pricing, revenue growth scale/leverage, offshore transition etc as we
are concerned with the impact of wage hikes only). For Infosys, the same hike
exerts a significantly lower negative impact of about 300 bps.
• Translated into operating profit in absolute terms, the said wage hikes bring
down MindTree’s absolute operating profits by 30%+ Y/Y. While for Infosys,
the decline is just about one-third at 10% (not factoring in revenue growth,
pricing increase and leverage as we are concerned purely with the impact of
wage hikes on the operating profits of the firm as it exists today).
• Taking Infosys’ ability to expand the pyramid (using more of the fresher pool)
as being more meaningful than MindTree (thus lowering the effective increase
in per capita wages), the divergence in impact on operating margins/operating
profits between the two for the same wage hike becomes even more dramatic.
• This analysis also tells us that the MindTree’s revenue has to increase ~25-
30% in FY12 to just stay still (keep operating profits flat Y/Y before product
investment write-offs). In other words, MindTree has to run a lot faster in
FY12 just to stay still, in a manner of speaking.
• Such a finding is generally true of mid-caps. The impact of wage hikes on
operating margins of mid-caps is much steeper than for TCS/Infosys (for the
same hike). We see the negative margin impact as being greater if:
• Employee costs constitutes a greater proportion of revenues
• Companies have greater proportion of offshore pay in their total cost
structure (like MindTree, Infotech Enterprises and Persistent Systems
which are more offshore-centric.) (Offshore wage inflation offshore
is 4-5x onsite wage inflation).
• We continue to be cautious of the undifferentiated, generic mid-cap.
Their adverse cost structure, as this note explains, is one reason. TCS
(OW) remains our top pick in the sector.
Infosys as a test case – ~ 300 bps margin impact in FY12 before pyramid benefits
• 54% of Infosys’ revenues is employee costs
• Two-thirds of employee costs is onsite wages and one-third is offshore wages.
• This implies that onsite wages = 35% of revenues (2/3*54), while offshore wages = 18% of revenues (1/3*54)
• Onsite expected to increase 3% i.e. 100 bps of impact on margins (35% *3%) = 105 bps….(a)
• offshore expected to increase 12% i.e. 230 bps of impact of margins (12%*18%) = 220 bps…..(b)
• Total impact pre-fresher hiring = 325 bps (negative)….(a) + (b)
• Pyramid benefit = 130-150 bps of positive benefits (c)
• Net-impact post pyramid benefit = negative 180-200 bps (a) + (b) - (c)
• Additional cost of 20% attrition assuming replacement hikes of 25% for the folks who leave = (18% of revenues or
offshore pay)*(20-15%)*25% = -ve 25 bps (the 15% marked in red indicates normal attrition of 15% which is replaced
by pyramid and hence, having no negative margin impact; only the excess attrition can be costly)….the assumption
here is that attrition is entirely offshore and there is minimal attrition onsite, which is typically the case.
Mindtree as a test case – a much more sobering impact in FY12 of same wage hikes
• 62% of revenues is employee costs (as against 54% for Infosys/TCS)
• Offshore costs is 60% of total employee costs while onsite costs are 40% (For Infosys, the onsite pay is about 60-65%
of total pay while offshore pay is lower at 35-40% of total pay). In other words, Mindtree being more offshore-centric
has a greater % of offshore pay in its total pay.
• This implies that onsite wages = 25% of revenues (40%*62), while offshore wages = 37% of revenues (60%*60)
• Onsite expected to increase 3% i.e. 75 bps of impact on margins (3%*25%)….(a) (For Infosys, this is 100 bps)
• offshore expected to increase 12% i.e. 450 bps of impact of margins (12%*37%)…..(b) (For Infosys, this is about 230
bps)
• Total impact = 525bps (negative)….(a) + (b) (For Infosys, this is about 330 bps)
• Pyramid benefit = 65-75 bps of positive benefits (c)…(MindTree’s ability to drive the pyramid is inferior to Infosys)
• Net-impact on margins post pyramid benefit = negative 450 bps (a) + (b) - (c)
Table 2 highlights how the same wage hike impacts margins for various players. The final impact is a function of the wage
composition as % of revenues and the relative proportion of offshore wages therein.
Conclusions
• For the same hike (onsite and offshore pay going up 3% and 12% p.a. respectively), the margin impact on an
offshore-centric company such as Mindtree is more than 2x Infosys (445 bps versus 180 bps).
• The impact can be even more drastic for a company such as Persistent Systems, for which offshore wages comprise
80% of its overall wages as offshore wage inflation is 4-5x onsite wage inflation.
• The generic, undifferentiated mid-cap will have to run faster in FY12 to just stay still (our model indicates that
MindTree’s revenues will have to grow 25% in FY12 to keep the absolute level of recurring EBITDA constant.
India Equity Research Reports, IPO and Stock News Visit http://indiaer.blogspot.com/ for complete details �� ��
India IT Services
Wage inflation concerns in the Indian IT industry
persist; the mid-cap has to run a lot faster to stay still
• Wage inflation concerns still persist in the Indian IT industry. We believe
that annual wage hikes in FY12 is likely to be at least 12-15% (offshore) and
3% (onsite). Offshore wage pressures are likely to remain particularly sticky
in view of (a) high domestic inflation in India and (b) continued attrition in
the industry evident from the Dec-10 results (with the exception of
TCS/Infosys, we note that attrition is still uncomfortably high, particularly
with the mid-caps – some of them such as MindTree and TechMahindra -
reported quarterly annualized attrition exceeding 30% for the Dec-10 quarter).
• The mid-cap is likely to suffer more as a consequence. We have already
seen select mid-caps attempt to counter this through a second-round of wage
hikes for FY11 (KPIT, Persistent Systems, NIIT Tech, Infotech Enterprises).
The adverse margin impact on the mid-cap is twice as that on large-caps for
the same percentage increase in wages (offshore and onsite) (in some cases
more than twice the impact). Given their lower operating margins, the impact
on absolute operating profits is even more adverse.
• Take MindTree (UW) versus Infosys (Neutral) as a case in point. A 12%
offshore wage hike and 3% onsite wage hike translates into a negative 520 bps
impact on MindTree’s margins for FY12 per se (excluding traditional levers
such as pricing, revenue growth scale/leverage, offshore transition etc as we
are concerned with the impact of wage hikes only). For Infosys, the same hike
exerts a significantly lower negative impact of about 300 bps.
• Translated into operating profit in absolute terms, the said wage hikes bring
down MindTree’s absolute operating profits by 30%+ Y/Y. While for Infosys,
the decline is just about one-third at 10% (not factoring in revenue growth,
pricing increase and leverage as we are concerned purely with the impact of
wage hikes on the operating profits of the firm as it exists today).
• Taking Infosys’ ability to expand the pyramid (using more of the fresher pool)
as being more meaningful than MindTree (thus lowering the effective increase
in per capita wages), the divergence in impact on operating margins/operating
profits between the two for the same wage hike becomes even more dramatic.
• This analysis also tells us that the MindTree’s revenue has to increase ~25-
30% in FY12 to just stay still (keep operating profits flat Y/Y before product
investment write-offs). In other words, MindTree has to run a lot faster in
FY12 just to stay still, in a manner of speaking.
• Such a finding is generally true of mid-caps. The impact of wage hikes on
operating margins of mid-caps is much steeper than for TCS/Infosys (for the
same hike). We see the negative margin impact as being greater if:
• Employee costs constitutes a greater proportion of revenues
• Companies have greater proportion of offshore pay in their total cost
structure (like MindTree, Infotech Enterprises and Persistent Systems
which are more offshore-centric.) (Offshore wage inflation offshore
is 4-5x onsite wage inflation).
• We continue to be cautious of the undifferentiated, generic mid-cap.
Their adverse cost structure, as this note explains, is one reason. TCS
(OW) remains our top pick in the sector.
Infosys as a test case – ~ 300 bps margin impact in FY12 before pyramid benefits
• 54% of Infosys’ revenues is employee costs
• Two-thirds of employee costs is onsite wages and one-third is offshore wages.
• This implies that onsite wages = 35% of revenues (2/3*54), while offshore wages = 18% of revenues (1/3*54)
• Onsite expected to increase 3% i.e. 100 bps of impact on margins (35% *3%) = 105 bps….(a)
• offshore expected to increase 12% i.e. 230 bps of impact of margins (12%*18%) = 220 bps…..(b)
• Total impact pre-fresher hiring = 325 bps (negative)….(a) + (b)
• Pyramid benefit = 130-150 bps of positive benefits (c)
• Net-impact post pyramid benefit = negative 180-200 bps (a) + (b) - (c)
• Additional cost of 20% attrition assuming replacement hikes of 25% for the folks who leave = (18% of revenues or
offshore pay)*(20-15%)*25% = -ve 25 bps (the 15% marked in red indicates normal attrition of 15% which is replaced
by pyramid and hence, having no negative margin impact; only the excess attrition can be costly)….the assumption
here is that attrition is entirely offshore and there is minimal attrition onsite, which is typically the case.
Mindtree as a test case – a much more sobering impact in FY12 of same wage hikes
• 62% of revenues is employee costs (as against 54% for Infosys/TCS)
• Offshore costs is 60% of total employee costs while onsite costs are 40% (For Infosys, the onsite pay is about 60-65%
of total pay while offshore pay is lower at 35-40% of total pay). In other words, Mindtree being more offshore-centric
has a greater % of offshore pay in its total pay.
• This implies that onsite wages = 25% of revenues (40%*62), while offshore wages = 37% of revenues (60%*60)
• Onsite expected to increase 3% i.e. 75 bps of impact on margins (3%*25%)….(a) (For Infosys, this is 100 bps)
• offshore expected to increase 12% i.e. 450 bps of impact of margins (12%*37%)…..(b) (For Infosys, this is about 230
bps)
• Total impact = 525bps (negative)….(a) + (b) (For Infosys, this is about 330 bps)
• Pyramid benefit = 65-75 bps of positive benefits (c)…(MindTree’s ability to drive the pyramid is inferior to Infosys)
• Net-impact on margins post pyramid benefit = negative 450 bps (a) + (b) - (c)
Table 2 highlights how the same wage hike impacts margins for various players. The final impact is a function of the wage
composition as % of revenues and the relative proportion of offshore wages therein.
Conclusions
• For the same hike (onsite and offshore pay going up 3% and 12% p.a. respectively), the margin impact on an
offshore-centric company such as Mindtree is more than 2x Infosys (445 bps versus 180 bps).
• The impact can be even more drastic for a company such as Persistent Systems, for which offshore wages comprise
80% of its overall wages as offshore wage inflation is 4-5x onsite wage inflation.
• The generic, undifferentiated mid-cap will have to run faster in FY12 to just stay still (our model indicates that
MindTree’s revenues will have to grow 25% in FY12 to keep the absolute level of recurring EBITDA constant.
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