For technology firms, Q1 may be a quarter to forget

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Summary

Macro headwinds amid the looming fears of a global recession have weighed on discretionary technology demand in key verticals such as banking, financial services and insurance and high-tech, and important geographies of US and Europe.

For India’s technology companies, the first quarter is typically a strong one. However, hopes are running low this time, even as large-cap information technology (IT) companies Tata Consultancy Services Ltd (TCS) and HCL Technologies Ltd kick off the June quarter (Q1FY24) earnings season for the sector on Wednesday.

“June 2023 will be an exception, with revenue declining for certain companies (Wipro, Tech Mahindra), flat for TCS and marginally growing for some (HCL Tech at 1%, Infosys at 1% q-o-q)," Kotak Institutional Equities analysts said.

Macro headwinds amid the looming fears of a global recession have weighed on discretionary technology demand in key verticals such as banking, financial services and insurance and high-tech, and important geographies of US and Europe. The delay in decision making by clients means that deal conversion pipeline would take longer than usual, resulting in slower revenue conversion, hurting sector’s revenue visibility for FY24.

In Q1, tier-2 IT companies could do better in revenue growth versus larger peers. Motilal Oswal Financial Services expects sequential constant current revenue growth of tier-1 companies to be in the range of -2.5% to +0.9%. Excluding L&T Technology Services Ltd, revenue growth of tier-2 companies is expected to fall within a wider range of -1.2% to +3.3%, the brokerage said.

As such, widely-held expectations of muted revenue growth at tier-1 techn-ology firms have raised worries of moderation in FY24 revenue growth guidance by Infosys and HCL Tech. In this backdrop, outlook on deal pipeline is crucial, given more traction in cost takeout deals and consolidation. With muted revenue growth, accompanied by wage hikes, there is not much comfort on operating margin front too. Some tier-1 companies could do slightly better than mid-caps, but overall, expect no fireworks in earnings before interest and tax (Ebit) margins. However, levers such as easing supply pressures, moderation in attrition, higher utilization and lower sub-contracting costs should partially help offset weaker margins.

Investors have been cognizant of the sector’s problems. So far in FY24, the Nifty IT index has lagged the Nifty 50, giving a mere 3% returns, compared with the latter’s 11% returns. Analysts point out that valuations of Indian tier-2 IT stocks are at a premium to tier-1 stocks. Amid this, the heightened uncertainty on the near-term demand conditions has increased preference for tier-1 IT stocks over their tier-2 counterparts. “We fear that the Indian tier-2 set would suffer more because of vendor consolidation under the pressured profit picture for customers, a less diversified revenue mix (client, service line, vertical), which could throw up negative growth surprises, and a larger exposure to non-Global 1000 clientele, whose profits are more vulnerable in the current macro environment," a Nirmal Bang Institutional Equities report dated 1 July, said.

To be sure, the road ahead does not appear smooth for IT investors. Sentiment for the stocks would continue to be muted until investors have enough confidence on recovery in revenue growth. A delayed pick-up in technology spending by clients could mean that revival will be gradual and could get further pushed to Q4FY24/FY25 than H2FY24 as is anticipated. In effect, consensus FY24 earnings estimates for IT companies risk being downgraded.

“We do not expect a recovery in discretionary spending in CY2023. However, what has changed is growing pipeline of cost take-out large and mega-de-als. Some IT companies have made deal announcements to this effect. Pickup in large deal momentum is critical for H2FY24 growth and laying foundation for FY2025 growth," Kotak analysts said.

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