Weak September quarter results, muted guidance: IT industry wades through challenging times

Report by Kotak Institutional Equities says firms are aggressively controlling costs

Travel restrictions will impact the movement of IT professionals from India and can affect ongoing technology projects of Indian IT companies at offshore locations in the West.

The IT sector has been reporting weak September quarter results. The results give an indication of the near-term outlook and also a larger view of what can be in store for the sector in FY 2024-2025. The results, which were a mixed bag, also highlighted the challenging times the sector has been facing currently and revealed what they are doing to overcome these.

There were mega deal announcements by a few companies even as a weakening discretionary spending environment was visible.

As per a recent report by Kotak Institutional Equities, the IT services aren't witnessing enough increase in profit to see through the tough times. The report observed that EBIT margin improved by 40-150 bps for TCS, Infosys and HCLT.

According to the report, the companies are a lot more aggressive in controlling costs. As the anticipated quick recovery did not take place, costs are being aligned to the actual demand.

Top-tier IT companies reported revenue declines or muted growth quarter-on-quarter, driven by weak discretionary spending in both North America and Europe, chiefly in the verticals of financial services, telecom and hi-tech. The report pointed out that cancellations, delays and re-prioritization continue to impact discretionary spending. Mid-tier companies reported divergent growth, led by Persistent.

During the quarter, Infosys and HCLT cut guidance, while Wipro provided far weaker guidance than expected due to the weak outlook for 2 HFY24 and the gap between deal signing and ramp-up.

The Q3 results also indicate that IT services companies do not see signs of a near-term recovery. The expectation is for elevated furloughs not just in industries such as BFSI, hi-tech and manufacturing but in other verticals as well. Higher impact from furloughs and lower working days lay the stage for another muted quarter in 3QFY24.

The good news is that there has been a record number of TCV (total contract value ) deals signed by quite a number of companies such as TCS, Infosys, HCLT and Persistent. However, deal wins were muted for TechM and Mphasis.

The Kotak report observed that the urgency of the pandemic era seems to have abated, with clients asking vendors to go slow on the execution of discretionary programmes. Experts at Kotak believe that in the CY 2024 budgets will be cleaner and clients will continue to spend on digital transformation journey. Many IT services companies took steps to defend their margins such as raising utilization rates, increasing productivity measures, and lowering the average cost of resources. The report highlighted that the hiring spree during Covid had led to lateral hiring at inflated salaries that were not fully compensated through pricing.

It is expected that there can be an unanticipated deterioration of demand and the costs of return to offices.
At the same time time, the deal pipeline is replenished and healthy and one can expect more mega deal signings. Cost optimization deals are common in a challenging environment. While TCS, Infosys and HCLT have an advantage, Wipro and TechM are on a weak footing and at risk in vendor consolidation events.

Vertical-wise growth is led by manufacturing, healthcare and energy segments which display resilience, while BFSI, hi-tech, telecom and retail remain tepid. We expect a recovery in telecom vertical revenues which will be driven by mega deal revenue conversion for select companies, the analysts said.

During the next FY 2024-2025, all eyes will be on discretionary spending by clients that remains elusive. Discretionary spending stabilization and uptick are critical for the growth of companies. The earliest signs of this would be visible only by the first quarter of the 2024 calendar year. Recovery in BFSI and hi-tech depends on the willingness to spend and better macro-outlook. The telecom vertical is in a tight spot and may take longer to recover but may throw up more cost take-out opportunities. The resilience of manufacturing, healthcare and energy verticals will be tested, as the US economic growth decelerates through CY2024.

There can also be an impact of generative AI as the adoption is still in the early stages, but prominent use cases showing initial promise include software development and conversational AI, which can lead to revenue deflation pressures. Participation in generative AI implementation provides opportunities as well, but is currently limited to PoCs and experiments. At the same time, experts believe that the US presidential elections in November 2024, which is likely to be dominated by the noise around H-1B visa and outsourcing, may impact decision making of clients.

Experts at Kotak say that hiring trends will not be positive and will further worsen as companies focus on internal fulfillment and reduce fresher hiring mandates. The net headcount declined even more on quarter-on-quarter across top-five companies, as companies reduce the intake of freshers and backfilling of attrition. Companies are pulling back on fresher hiring targets and the focus is on redeploying existing talent wherever projects are available, given the headwind from delays and pause in certain projects/programmes. At the same time attrition rates continued sharp descent and are much below pre-Covid levels. IT services companies have also doubled down on margin improvement by replacing subcontracting and thinning bench.

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