IT: Margin recovery hopes need a reset too as revenue revival gets delayed

The IT sector’s margin trajectory has been a mixed bag in recent quarters. (Pixabay)
The IT sector’s margin trajectory has been a mixed bag in recent quarters. (Pixabay)

Summary

  • Expectations of a significant revival in the revenues of IT services companies have now been pushed to FY26 as there aren’t many solid signs that the pain of muted demand has bottomed out

The Street’s expectations of a significant revival in the revenues of information technology services companies have now been pushed to FY26. Consequently, the Nifty IT index has underperformed the Nifty 50 index so far in 2024.

Sure, recent commentary from global IT giants Accenture and Cognizant suggest that demand has not deteriorated. Even so, there aren’t many solid signs that the pain of muted demand for discretionary IT services has bottomed out.

The slower conversion of deal wins continues to weigh on the sector’s revenue visibility. Thus, investors must not expect any fireworks from Indian IT companies in the April-June quarter (Q1) of the FY25 earnings season. Sector bellwether Tata Consultancy Services Ltd (TCS) will be the first to announce its Q1 results on 11 July.

Also Read: Gen AI takes centre stage at AGM of TCS and Infosys

In the current backdrop, margin recovery hopes also need to be tempered and refreshed.

“With street rebound hopes pushed out to FY26 already, next casualty could be hopes of margin increases over next two years," Ambit Capital said in a report.

The brokerage house expects margins to stay below pre-Covid levels and moderate over FY24-26 by 50 basis points (bps) to 20.5% for tier-1 IT companies. This is contrary to the street’s hopes of margin increases. One basis point is one-hundredth of a percentage increase.

“This could be the quarter where margin expectations for consensus get toned down," Ambit said.

Margin targets

The sector’s margin trajectory has been a mixed bag in recent quarters. As companies battle muted revenue growth, they increased emphasis on cost-optimisation measures. Margin trends have varied across tier-1 and tier-2 packs also depending on their respective hiring/attrition levels and sub-contracting expenses.

In Q4 of FY24, TCS maintained its medium-term comfort margin target of 26-28%. HCL Technologies Ltd retained its aspirational margin band of 19-20%, although it said it could take a while to meet this target due to the current low-growth environment.

Among mid-caps, Persistent Systems Ltd retained its 200-300 bps margin expansion aspiration for the next two-three years. For L&T Technology Services Ltd, increased investments in people and technology are expected to lead to more than a 100 bps Ebit margin decline to about 16% in FY25. Ebit is earnings before interest and tax.

As companies tackle different challenges, a uniform margin trend is unlikely in Q1. Headcount addition across large IT companies is expected to be modest, given the near-term uncertainty. Improving utilisation and productivity levels are likely to be the key focus.

That said, travel-related expenses have returned on the back of increased on-site expenses, where IT companies are required to provide for visa costs. Plus, pricing pressures faced by large companies indicate elevated competitive intensity.

Also Read: Q1 results preview: From TCS to HCL Tech, IT sector revenue growth expected to improve sequentially

Analysts at JM Financial Institutional Securities Ltd expect large-cap players to report -110 to +50 bps sequential Ebit margin movement in Q1. Wage hikes and lower growth are expected to weigh on margins for TCS and HCL, respectively.

Infosys’ margin has tailwinds from the absence of visa costs and a partial reversal of a one-off impact in Q4, it said.

“We expect 75-100 bps margin contraction for Coforge/Persistent without wage hike, on seasonal factors (Visa)/deal transition cost," said JM Financial’s analysts.

As things stand, the impact of cross-currency movements is expected to be minimal in Q1. Still, a slow revenue trajectory, the transition costs of large deals, and investments in capabilities are key margin headwinds that companies face. Clouded by these issues, the sector’s valuation appears expensive.

“FY25 guidance ranges are unlikely to change, which may drive earnings cuts," Jefferies India pointed out in a report dated 2 July. “Given the rich sector valuations amid limited demand recovery, we remain selective."

Jefferies added that Infosys is its only pick.

 

 

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