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Investors in shares of Indian information technology (IT) services companies cannot afford to miss the woods for the trees with the threat of a global recession lingering.

Margin and revenue growth trends have been two crucial parameters to gauge the financial health of IT service providers. However, against the current backdrop, IT investors should also closely track other indicators for more cues on future demand. These include hiring momentum, deal pipeline, and revenue growth of top clients.

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“The clients of Indian IT companies start planning their IT spending budgets for the next year post September. Hence, management commentary giving any insight on this would be critical," said Kumar Rakesh, a senior automobile and technology analyst at BNP Paribas Securities India.

So far, despite the deteriorating global macroeconomic environment, commentary from IT companies has remained upbeat, especially on the demand front. True, the effects of changes in global macros tend to reflect on earnings with a lag. However, with the September quarter (Q2FY23) results, the tone of management could change. “We believe the disconnect between macro (such as weakening US and European economy, moderation in demand) and micro (commentaries from management) will no longer continue," analysts at ICICI Securities Ltd said in a report on 1 October.

Among verticals, banking, financial services and insurance (BFSI) and retail contribute a major chunk to the revenues of the top four IT companies. Increased digitisation after the covid pandemic gave IT demand from the BFSI sector a boost. However, there is a catch. “IT spending at the top six US banks has moderated to 4.2% year-on-year (y-o-y) in 1HCY22 (versus 7.3% in 1HCY21 and 5.3% y-o-y growth in CY21). This is contrary to the positive BFSI demand narrative," said analysts at Ambit Capital in a report on 4 October.

The bright spot is that the sector’s earnings before interest and tax (Ebit) margin has most likely bottomed out in Q1FY23. That said, headwinds such as wage revisions, increased travel costs, and elevated subcontracting expenses, mean recovery would be gradual. Higher utilization levels, cost rationalization, and a depreciating rupee are some tailwinds, but they would offer limited cushion to margins in Q2.

ICICI Securities expects a 30-90 basis points (bps) sequential rise in Ebit margin for tier-1 IT and an average about 100bps sequential drop for tier-2 IT. What remains to be seen is whether tier-1 IT companies retain their FY23 revenue growth guidance.

The sector’s attrition is expected to have peaked and should start declining on an annualized basis across companies. However, hiring could moderate in the quarters ahead because of macro uncertainties and the common furloughs that happen in the December quarter. Given this, IT investors have understandably been nervous. The Nifty IT index has fallen by 24% so far in FY23, underperforming the benchmark index Nifty50. The sector’s valuation multiple measured with regard to price-to-earnings have cooled-off of late, but are still higher than historical average. Some analysts note that the IT sector’s valuations have factored in a slowdown, but not a recession. If recession risk was to actually play out, valuations could further correct.

Tier-1 and tier-2 IT valuations at 22.6x and 25.2x are still around 24% and 46% premium to the pre-covid three-year average, said Ambit’s analysts. “We expect limited positive surprises either on growth or on margin in 2Q results. The Street’s expectations on both growth and margins remain high and might moderate post results," they said.

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