IT Q1 Earnings Review: MOFSL likes HCL Tech and LTI Mindtree among largecaps, Persistent Systems in midcaps

The IT services companies within the Motilal Oswal Financial Sevices (MOFSL) Universe reported a strong performance, surpassing estimates in the June quarter (Q1FY25), with a median revenue growth of 1.2 percent QoQ in constant currency (CC). In a review note, brokerage house MOFSL observed a slight shift in focus for IT firms due to a mild recovery in discretionary spending among BFSI clients. 

This shift is moving from cost-takeout deals to "high-priority" transformation deals in certain areas. However, overall pressure on discretionary spending remains. The brokerage believes the cycle might be turning, as clients begin to reinvest their savings from cost-reduction programs to address technological debt.

With most IT firms having reported their June quarter earnings, MOFSL has identified its top picks in the sector. The brokerage prefers HCL Tech and LTI Mindtree among largecaps, and Persistent Systems in the mid-cap space.

HCL Tech has effectively managed seasonality and is set for a strong second half of FY25, with a realistic 2.5 percent growth target. Its free cash flow (FCF) metrics have significantly improved, now aligning with those of TCS and Infosys, justifying a premium valuation, according to MOFSL.

MOFSL also noted that LTI Mindtree is well-positioned for growth in data engineering and ERP modernisation, enabling it to capture pre-GenAI expenditures. The brokerage anticipates LTIM to outperform its large-cap peers, expecting low double-digit constant currency growth for FY26.

For Persistent Systems, the brokerage highlighted its strong earnings growth and strategic shift to platform-based services for GenAI spending. MOFSL projects a 17 percent dollar revenue CAGR and an EPS CAGR of over 25 percent, supporting a premium valuation multiple.

Among stocks, MOFSL highlighted that Infosys and LTIM beat revenue growth expectations, while HCLT exceeded estimates in both revenue growth and margins. Persistent Systems also delivered strong revenue growth, beating expectations. On the other hand, Cyient and LTTS missed expectations on both revenue growth and margins, with Cyient issued a revenue guidance cut. Wipro also experienced a significant miss in margins.

Regarding EPS upgrades/downgrades, MOFSL informed that Infosys saw upgrades of 3 percent for FY25E and 6 percent for FY26E. Meanwhile, L&T Tech experienced EPS downgrades of 5 percent for FY24E and 1 percent for FY25E. Cyient's DET business saw significant EPS reductions of 17 percent for FY24E and 6 percent for FY25E, whereas Zen Technologies received upgrades of 6 percent for FY24E and 1 percent for FY25E.

A closer look at Q1FY25

Healthy revenue growth: According to the brokerage, Tier-1 IT companies experienced healthy median revenue growth of 1.5 percent QoQ in constant currency (CC), while Tier-2 companies reported a lower growth rate of 0.8 percent QoQ CC, primarily due to Cyient's poor performance of -5.0 percent QoQ CC. Excluding Cyient, Tier-2 companies achieved an in-line growth rate of 1.6 percent QoQ CC.

Notable underperformers included Wipro, with -1.0 percent QoQ CC, and Cyient, with -5.0 percent QoQ CC. In terms of margins, Tier-1 companies experienced a slight contraction of 20 basis points (bp) QoQ, while Tier-2 companies saw a larger contraction of ~150 bp QoQ, mainly driven by Cyient's 250 bp QoQ margin decline, informed MOFSL. Tier-1 margin pressures were largely due to wage hikes and a reduction in HCLT's ER&D margin. Tier-2 companies' margins were affected by one-off expenses, higher SG&A, and Visa costs for certain firms, it added.

TCV back to normal run-rate: In terms of total contract value (TCV), deal growth for Tier-1 companies has returned to normal levels, decreasing by 23 percent QoQ, with Infosys as a notable exception in Q1. Meanwhile, Tier-2 companies also followed a similar trend with a 20 percent QoQ decline. Infosys reported strong deal wins in Q1, securing 34 large deals with a TCV of $4.1 billion, 57.6 percent of which were net new deals, highlighted the brokerage. Among Tier-2 companies, Coforge showed moderate growth due to a high base in Q4, while Mphasis reported strong growth from a low base in Q4. The book-to-bill ratio in Q1 was a solid 1.0x for both Tier-1 and Tier-2 companies, it noted.

What changed in 1QFY25?

BFS Sector Sees Growth and Cautious Optimism: The Banking and Financial Services (BFS) sector has shown signs of growth in Q1FY25 after several quarters of sequential revenue declines. This development offers some hope, though it is too early to declare a full recovery. Potential interest rate cuts could encourage spending and support recovery, but the threat of a recession might worsen balance sheet issues, possibly hindering the sector's rebound, according to MOFSL.

Shift in Focus from Cost-Cutting to Transformation: Clients are moving away from cost-cutting strategies towards prioritising high-impact transformation initiatives. This shift includes resuming data and ERP modernisation projects that were previously postponed due to inflation concerns. While the pace of adoption is cautious, vendors with strong transformation offerings are well-positioned to benefit, as noted by the brokerage.

What challenges remain?

Communications sector challenges: As per MOFSL, the communications sector continues to face difficulties as clients deal with the ongoing effects of substantial capital expenditures and high interest rates. While potential rate cuts may offer some relief, a significant increase in technology spending is likely contingent on a shift from 5G infrastructure investments to service-oriented spending, warned the brokerage. This transition depends on the widespread adoption of enterprise 5G use cases.

Weakness in hi-tech spending: In the hi-tech sector, spending is increasingly directed towards hardware and semiconductors. Although product engineering software expenditures are expected to follow this trend, there will likely be a delay. This ongoing shift is anticipated to impact the sector in the foreseeable future, according to MOFSL.

As the IT sector adjusts to new dynamics, MOFSL has highlighted key picks for investors, favoring HCL Tech and LTI Mindtree among large-cap stocks, and Persistent Systems in the mid-cap space. While some companies, like Infosys and LTI Mindtree, exceeded expectations, others, including Cyient and LTTS, faced challenges with revenue growth and margins. Looking forward, the sector faces challenges in communications and hi-tech spending, but signs of growth in BFSI and a shift towards transformation initiatives provide cautious optimism. The evolving landscape underscores the importance of strategic investment and adaptation to market trends.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.