IT stocks factor in recovery, but business is on the slow grind

The Nifty IT index rose around 14% in the September quarter, compared to the Nifty50's 7% returns, reflecting hopes of demand recovery.

The US Federal Reserve took a monetary policy pivot, cutting rates by a jumbo 50 basis points (bps) in September. One basis point is 0.01%. This major event is considered a trigger for BFSI (banking, financial services and insurance) clients to revive their discretionary IT spending, which has been languishing lately.

IT stocks seem to be pricing-in turnaround, but on the ground, it may take at least a few more quarters before clarity emerges on client budgets, which usually happens post the December quarter (Q3). Moreover, the recent management commentary and guidance of global IT giant Accenture Plc indicates no significant change in the demand environment, with clients continuing to focus on cost-optimization deals. So, irrespective of the rise in stock prices, the sector’s September-quarter earnings (Q2FY25), which is usually seasonally strong, may bring little comfort.

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“IT services demand has likely not turned yet, at least not for good. Pockets of strength in US BFSI, though sustained, have not expanded to adjacent areas,” said JM Financial Institutional Securities Ltd in a report on 30 September.

“In essence, there is no sector-wide tailwind just yet,” it added. Large-caps under the brokerages’ coverage could see an aggregate 0-3.5% sequential constant currency revenue growth, while mid-caps could do better at 2.8-4.6%."

Revenue growth

Mid-caps have been beating large-caps in revenue growth for the past several quarters, and that is likely to continue in Q2FY25. Further, this time, the sector’s US dollar revenue growth is also likely to gain from favourable foreign currency movement. Amid this, a revision in FY25 revenue growth guidance by Infosys Ltd and HCL Technologies Ltd could give some cues for the second half of the fiscal year, which is impacted by furloughs. Disappointments here could prompt earnings cuts for FY25/FY26.

Earnings before interest and tax (Ebit) margin is expected to be largely steady aided by better productivity. Employee attrition has mostly bottomed out and focus remains on margin levers such as lower subcontracting cost, improving employee pyramid and rationalization of wage hikes.

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“Q2 margin recovery should be better than Q1, as the one-time visa costs and deal ramp-up expenditures are behind, while a few names have deferred their compensation revision cycle to H2,” said analysts at Prabhudas Lilladher.

Wipro Ltd, Cyient Ltd and Persistent Systems Ltd have rolled out wage hikes in Q2, and hence, margins for the quarter are expected to come under pressure, it said.

More importantly, deal wins are expected to be focused on cost-takeout projects and, hence, will be longer in tenure. A slower conversion of the deal pipeline into revenues has been a sore point for IT investors. “Mega deal activity has been soft, in our view. Deal wins will be less exciting at a broader level across companies,” said a Kotak Institutional Equities report dated 30 September. The large deal total contract value (TCV) for Infosys could be over $3 billion, but TCV growth for Tata Consultancy Services, Mphasis Ltd, Coforge Ltd could be muted or may decline year-on-year, it said.

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While not impressive, TCV of HCL will be significantly above Q1FY24 levels due to a low base, Kotak added.

Meanwhile, the sector’s valuations, despite moderation, do not appear enticing given the continued lack of revenue visibility. The timing and quantum of IT spends in client budgets remains a key monitorable. The outcome of the upcoming US elections may also have a ripple effect on the client's spending outlook and could be a downside risk.