In the June quarter (Q1FY25), the IT sector witnessed a broad-based recovery across key verticals and geographies, suggesting sustained execution for the rest of the year. However, with strong optimism already factored into valuations, there is limited upside potential, said Prabhudas Lilladher in its Q1 review note.
As per the brokerage, the Tier-1 IT stocks showed a notable turnaround in Q1 after five quarters of underperformance compared to Tier-2 IT stocks. Despite some Tier-2 companies underperforming in Q1, management commentaries remain positive for the rest of FY25, as reflected in a 14 percent valuation premium over Tier-1 (up from parity last quarter), it noted. Nevertheless, Tier-2 earnings growth may face pressure due to weak Q1 margins and pending wage revisions, it cautioned.
Prabhudas Lilladher remains selective on Tier-1 companies with diversified business models and attractive valuations. HCL Tech is highlighted as a top pick, with corrections in TCS and LTIM potentially presenting attractive opportunities.
According to the brokerage, Q1FY25 showed a relatively encouraging median revenue growth of about 2 percent YoY for the sector (both Tier-1 and Tier-2), a notable improvement from the sub-1 percent YoY growth in the previous two quarters.
On a QoQ basis, median revenue growth for the IT sector (Tier-1 + Tier2) came in at +1.2 percent CC. It further informed that Tier-1 companies outpaced Tier-2 after five consecutive quarters and reported median CC growth of 1.5 percent QoQ, while Tier-2 revenue growth came in at +0.8 percent QoQ CC.
"Q1 saw a rebound in operating performance after two consecutive quarters of weak topline growth. Although growth was partly aided by quarterly seasonality, the underlying demand has also been constructive across verticals and geographies," said the brokerage.
Key growth areas like BFSI and Retail, which had been inconsistent, aligned well in Q1, and Communications experienced its second consecutive quarter of growth, highlighted PL. This broad-based growth was driven by improved macroeconomic sentiment and increased spending beyond cost-saving measures. Although the total contract value (TCV) for deals has moderated sequentially to around USD 21 billion, it aligns with historical norms, it stated.
"Deal TCV (Tier-1 + Tier-2) during the quarter was moderated at $21 billion (down 23 percent QoQ) over 4Q (reported notable mega wins), with majority of the names reporting a sequential decline. However, Q4 witnessed several non-critical projects being cancelled or deferred, while Q1 saw the resumption of some high-priority or saving-led transformation projects, in addition to the ongoing cost-focused deals," noted the brokerage.
The brokerage further pointed out that deal conversion rates are improving due to the resumption of high-priority transformation projects and investments in GenAI. This improvement is reflected in a moderating book-to-bill ratio of 1.0x in Q1, up from a historical average of 0.8x. The reduction in headcount and expected increase in fresh recruitment, combined with optimised utilisation, indicate a sustained demand recovery, it further noted. PL expects the margin recovery to rely on revenue growth, as other optimisation levers are nearly fully utilised.
Limited margin recovery: According to Prabhudas Lilladher (PL), the sector's operating margin experienced a slight decline of 20 basis points to 19.5 percent, with Tier-1 companies showing a 20 basis point drop compared to a 50 basis point decline in Tier-2 companies. PL highlighted that Tier-1's better margin performance was supported by net headcount additions (excluding INFY and HCLT divestments), whereas Tier-2 faced net reductions (excluding Coforge). The weaker margin performance in Tier-2 is attributed to a lack of operating leverage and the need for immediate onsite resource fulfillment during Q1, it noted.
Outlook: PL also highlighted that despite outperforming expectations, Tier-1 companies (excluding INFY) generally maintained their guidance or outlook for the year. In contrast, Tier-2 companies (excluding CYL and BSOFT) expressed confidence in achieving industry-leading growth, supported by a strong deal pipeline and the continued strengthening of key verticals, it pointed out. With most Tier-1 companies surpassing Q1 growth consensus, the focus has shifted to meeting FY25 revenue targets for companies like INFY and HCLT. Given the growth uptick in Q1 and early signs of demand recovery beyond critical business areas, a constructive recovery is anticipated to continue in the coming quarters, predicted the brokerage.
As per the brokerage, within Tier-1, INFY led with a 3.6 percent QoQ constant currency (CC) revenue growth, followed by LTIM with 2.6 percent QoQ CC growth. HCLT was an exception, reporting a 1.6 percent QoQ CC decline, while Wipro saw a 1.0 percent QoQ CC decrease. On the margin front, PL noted that TECHM excelled with a 115 basis points QoQ improvement, followed by INFY and LTIM with 100 and 30 basis points QoQ improvements, respectively. In contrast, TCS and HCLT experienced notable declines of 130 and 50 basis points QoQ, due to compensation revisions and project runoffs.
Meanwhile, in Tier-2, Persistent and Zensar led with 5.6 percent and 4.3 percent QoQ CC growth, respectively, while Cyient reported a 5.0 percent QoQ CC decline. Persistent also stood out with an 85 basis points QoQ margin improvement, whereas CYL and LTTS saw sharp declines of 260 and 130 basis points QoQ due to project ramp-down and seasonality, respectively, informed the brokerage.
Prabhudas Lilladher's Q1FY25 review indicates a broad-based recovery in the IT sector, with Tier-1 companies notably outperforming their Tier-2 counterparts. While the overall median revenue growth improved to about 2 percent YoY, Tier-1 companies like INFY and LTIM showed significant QoQ growth. Despite this, valuations reflect strong optimism, limiting further upside potential. Tier-2 companies, though confident due to a robust deal pipeline, face challenges from weak margins and pending wage revisions. The sector's margin recovery is expected to depend on revenue growth, with a constructive recovery anticipated in the coming quarters. Key players like HCL Tech are highlighted as top picks, while corrections in TCS and LTIM could present attractive opportunities.
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.
