Are IT investors counting chickens before the eggs hatch?

The commentary of Indian IT companies on client IT budgets and demand conditions will be crucial. (Mint)
The commentary of Indian IT companies on client IT budgets and demand conditions will be crucial. (Mint)

Summary

After an unusually solid September quarter, not a single mega deal was announced by Indian IT during the third quarter. A weak FY24 exit looks imminent

The Nifty IT index ended 2023 with a good 24% return, driven by higher movement in December. Investor sentiment towards the sector revived with expectations for interest rate cuts by the US Federal Reserve in 2024 getting louder. A scenario of easing interest rates bodes well for the banking, financial services and insurance sector–a key demand driver for the Indian IT industry. This is expected to propel muted discretionary spending by companies on software and related requirements.

While the street is looking at the bright side of the story, the optimism needs to result in higher deal conversions and, thus, better revenue growth. But it may help to keep hopes low, for now.

 

 

The December quarter (Q3) is seasonally weak for the Indian IT sector due to furloughs and fewer working days. Further, the adverse impact of furloughs on revenues could be accelerated on prevailing client caution, prioritising of IT expenses, extended timeliness for deal closures, and slower executions.

 

Segment wise, the slowdown in BFSI, retail, hi-tech, and communications is expected to continue. Demand recovery in the US and Europe is also expected to be muted.

“During Q3FY24, we expect aggregate revenue growth for our coverage universe to remain muted at 0.8% QoQ constant currency, given the seasonal impact of furloughs, which are deeper this year," said Jefferies India in a report on 29 December.

While sequential growth in the third quarter improved by 40 basis points versus Q2, it was the slowest aggregate growth in the third quarter of any year in the past decade, Jefferies added.

Moreover, after an unusually solid Q2FY24, the deal win momentum is expected to have been tepid in Q3FY24.

“The (September) quarter was exciting, with several mega-deal announcements," Kotak Institutional Equities said. “The commentary about a healthy pipeline by companies indicated that more could follow in the (December) quarter."

However, not a single mega deal was announced by Indian IT during the quarter, Kotak’s analysts pointed out in a report on 3 January. In this backdrop, commentary on momentum in cost-take out deals, a saving grace for the industry in the absence of discretionary digital transformational projects, will be important.

Infosys Ltd recently saw a global client terminate a multi-year contract worth $1.5 billion. Also, global IT giant Accenture’s latest results, often seen as an indicator for future performance of large Indian IT companies, indicate no visible greenshoots of demand revival.

The commentary of Indian IT companies on client IT budgets and demand conditions in the ongoing fourth quarter and for financial year 2024-25 will be crucial. Lower revenue guidance by tier-1 and tier-2 IT companies would be dampener.

Amid expectations of muted revenue growth in Q3, margin movement is likely to be mixed and would vary across companies, depending on cost rationalisation measures and the impact of wage hikes. With supply-side challenges easing, trends in hiring and attrition will decide the sector’s profitability outlook.

Apart from these, the impact of company-specific factors such as recent senior-level exits at Infosys and Wipro, and Mohit Joshi’s strategy to turn around Tech Mahindra Ltd will be closely watched.

Also, valuations do not provide comfort as revenue visibility is still bleak, keeping the sector exposed to earnings downgrades. Tier-1 IT companies are trading at FY25 price-to-earnings multiples of 20-30 times, show Bloomberg data. Some tier-2 stocks are even more expensive.

A weak FY24 exit looks imminent for the Indian IT sector, according to JM Financial Institutional Securities Ltd. “Longer furloughs and absence of budget flush (spending/investments spree) are clear signs of weak demand," it said in a report.

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