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May 27, 2019

Bulging staff cost, shrinking margins

Operating margins of IT firms to shrink yet again, as H-1B visa rules continue to curb arbitrage

Indian information technology (IT) services companies need to write a new code to debug rising staff costs.


Traditionally, the sector has relied on labour arbitrage for maintaining margins, but that gap has been narrowing owing to various market forces - mainly changing US policy stance towards H-1B visas.


Employee expenses which account for nearly 60-65% of total operating costs and cost per employee for Tier 1 players rose faster at ~17% and ~9% on-year in fiscal 2019, respectively, compared with ~6% and ~3% a year before. For mid-tier players, the increase in employee expenses was ~13% on-year for nine months ended December of fiscal 2019 as many are yet to declare fourth quarter results.


Such an increase in employee costs can be attributed to tightening of visa norms for Indian players, resulting in higher onsite costs for them. Ever since the US government tightened its H-1B visa policy in 2017, challenges have mounted for the sector. That year, Indian-origin employees were the largest consumers of H-1B visas at 63% of initial employment, so the sudden change meant fulfilling onsite client requirements became tough.


To be sure, Indian IT players have had an offsite-onsite employee ratio of 80:20. Employees with H-1B visas have been at the core of their strategy, given that they cost ~20% cheaper than US-based employees. Further, the unemployment rate in the US technology sector was only 1.8-2.0% in calendar 2018, compared with an overall unemployment rate of 3.8-4.0%. So, the limited staff availability is expected to lead to higher employee costs associated with hiring US locals.


A deep dive into this issue shows the onsite costs of Indian IT companies would continue to rise and put their profit margins at risk.


Margins have been declining structurally for the past five fiscals, as billing rates and utilisation stabilise, so rising employee costs will only add to the pressure. Employee utilisation was high at ~85% in fiscal 2019, with only a marginal room for improvement in the future. Billing rates are expected to remain under pressure, as traditional services become commoditised.


CRISIL Research expects revenues to grow by 7-8% in dollar terms for the sector in fiscal 2020, helped by double-digit growth in digital services. Operating margin is forecast to decline 30-80 bps for the sector in fiscal 2020 as local hires increase for onsite job, who cost 25-30% more than their H1-B counter parts.


Players can try to optimise onsite costs by resorting to the pyramid model, wherein college graduates are hired at $50,000-60,000 in a higher proportion and the rest filled with a few domain experts at a higher cost, fewer onsite bench resources, and keeping variable salaries depending on the outcome of projects. Focus on moving up the value chain in digital services could also play a role to offset rising employee cost.