Indian IT Services To Report Muted July-September Quarter Amid Macro Headwinds

The Indian IT services sector is expected to report another muted quarter for July-September 2023, as macroeconomic uncertainties continue to weigh on technology spending by clients.

Leading brokerage firms predict the sector will post modest sequential revenue growth amid soft demand environment, with growth in the range of only 0%-1% on the quarter.

“We expect the Indian IT sector to witness a muted 2QFY24, with CC revenue growth at 1% QoQ as continued macro uncertainty is leading to inaction and hence, a slowdown in discretionary IT spend, despite strong deal wins,” said IIFL Securities in a report.

IIFL expects Tier 1 IT companies like TCS, Infosys and HCL Technologies to report 0.5% quarter-on-quarter CC revenue growth, while Midcaps will fare slightly better at 1.9%.

Emkay Global predicts a median revenue growth of 1.5% for its coverage universe, which it says is among the “slowest observed over the last decade, despite a marginal impact from FX fluctuations.”

Motilal Oswal Financial Services expects Indian IT companies to post muted 0.4% QoQ CC revenue growth in dollar terms. “2QFY24 is likely to be incrementally better than 1Q. But nowhere close to what most players envisaged at year-beginning. Hopes of finding a bottom in 1H has not materialised, we believe, as project ramp downs/cancellations continue,” it said.

Slow Ramp Ups, Client Spending

According to brokerage firms, the continued delay in decision making by clients amid uncertain economic environment has impacted new deal ramp ups as well as conversion of the strong deal pipeline built over past few quarters. Clients across verticals like BFSI, retail, hi-tech and manufacturing remain cautious in their IT spending.

“Our interactions with industry participants indicate continued weakness in BFSI across geographies reflecting weak macro environment,” said Dolat Capital in its preview note.

Emkay Global highlighted that sectors like BFSI, Retail, Hi-Tech, and Communication continue to show signs of softness. It expects manufacturing vertical to also see moderation in growth this quarter after reporting 1% QoQ decline in Q1.

Motilal Oswal Financial Services believes the shift in spending patterns towards cost efficiency initiatives has resulted in increased deal momentum related to those areas. However, discretionary spends remain muted impacting the overall growth.

“Ramp-downs and cancellation even mid-cycle (of budget) suggest a) on-going unwinding of excess IT spend; and b) more frequent budget reviews, thus limiting visibility,” it said.

Silver Lining

Even as uncertainties dampen discretionary IT spending, the same factors are also likely to drive more companies to explore cost-take-out deals, analysts said.

They said Indian IT companies seem to be benefiting from increased deal wins focused on cost optimization and efficiency improvements by clients looking to cut costs amid inflationary pressures.

“Our stance on slowdown in IT services remains intact for near term as OECD global forecast continues to see further cuts in GDP growth estimate from 2.9% to 2.7% for CY24 (against Average of 3.3% for CY15-19). Persistent inflation and delayed rate cuts for CY24 imply macro pressures will remain, culminating into uncertain IT spends,” said Dolat Capital.

Emkay Global expects collective deal total contract values (TCV) for Indian IT companies to remain steady or improve sequentially in Q2 after declining 1% QoQ in Q1. However, it cautioned that elongated ramp-up cycles for these deals will limit revenue conversion in the quarter.

IIFL also highlighted that deal win momentum has picked up, driven by large cost takeout deals across companies like TCS, Infosys and HCL Tech. But it too does not expect meaningful revenue contribution from these deals in Q2.

Margin Outlook Stable

The silver lining for IT companies this earnings season could come from the margin front — an area that has been a pain-point for these companies for nearly two years now.

Brokerages expect most companies to report steady operating margins, helped by tighter control of costs like sub-contracting, deferral of fresher hirings and lower variable payouts amid business slowdown.

Some companies have also deferred or staggered wage hikes till later part of the year to provide margin support.

“For Q2 among Indian IT Tier-1 companies, TCS/HCLT/LTIM should lead the way with 1.8% QoQ in CC followed by INFY (+1.2%) while Wipro (-0.3%) and TechM (-1%) are expected to see sequential decline. Among Tier-2, Persistent should lead the growth with 3% QoQ, followed by Mphasis (2.5%), Coforge (2%), and LTTS (2%),” said Dolat Capital.

“While growth moderation is a key headwind. A sharp margin focus – optimising sub-con expenses, pyramid correction, fixed cost rationalisation – is likely to help players eke out margin expansion in 2Q. We expect top-4 players to report (10)-50 bps EBIT margin expansion QoQ,” Motilal Oswal Financial Services added.

Guidance Cuts

Given the continued uncertain demand environment, brokerages expect most IT companies to narrow down their full year revenue growth guidance to the lower end of the range.

Some forecasters predict more drastic cuts in projections as well.

“We expect most of the companies to narrow down their FY24 revenue growth guidance to lower end, including HCLT, LTIM, LTTS and CYL. However, CY24 growth can see improvement, as signed but stalled transformation deals as well as increased number of cost takeout deals, start ramping up, with clarity on CY24 budgets in 3Q,” said IIFL.

“We therefore see potential guidance cut by both HCL (4-6% from 6-8%) and Coforge (12-14% from 13-16%) as a soft 2Q raises 2H ask materially,” Motilal Oswal stated.

Emkay Global expects the weakness seen in Q1 to sustain with “no meaningful signs of recovery or deterioration” across companies and verticals. It believes Tier 2 IT companies could see further moderation in growth.

Top Picks

In terms of stock picks, brokerages continue to prefer Tier 1 IT companies over Tier 2 names, given their strong balance sheets, diversified portfolios and attractive valuations. Among large caps, TCS, Infosys and HCL Technologies find favour given their capabilities and positioning.

“We continue to prefer Tier-I players over their Tier-II counterparts, given the former’s attractive valuations (one-year forward median 22x), payout yield (median 4.1% FY25E), and diversified business portfolios. Among Tier-I players, we prefer TCS, HCLT, and INFO,” said Motilal Oswal.

“We prefer TCS and INFO among large caps, and, COFORGE, PSYS and LTIM among mid-caps on better growth visibility,” IIFL recommended.

For mid-caps, L&T Technology Services and Coforge are recommended as top picks based on their recent deal wins and industry positioning.

Despite the upcoming muted results, analysts remain positive on the medium to long term outlook for Indian IT, subject to commentary around demand environment from the companies.

IT companies, including Infosys and TCS, are scheduled to report their results next week.