Weak demand outlook continues and near-term challenges persist

The IT companies has delivered weak sequential growth for the last two consecutive quarters, and it is expected that the underperformance of growth for top-tier IT services firms is likely to continue in coming one or two quarters owing to weak seasonality, elevated focus on cost efficiency initiatives, continued softness in discretionary spends. Commentaries of IT services companies don’t indicate any recovery of demand environment in the near-term, which was the expectation at the beginning of the year. Nonetheless, selected IT services firms has reported record high deal TCVs (Total contract value) in Q2FY24. Additionally, it is expected that a  modest recovery in discretionary spends in CY24 on the back of stabilization of macro concerns. The ramp up of deal TCVs, a gradual recovery in discretionary spends and strong deal pipeline are likely to accelerate the growth of Indian IT in FY25E.

Scope of Margin Improvement

IT services firms aggressive cost control measures are likely to help them report improvement in margins in 2HFY24. Further, analysts believes that there is a room for Indian IT services companies to improve their margins in FY25E on the back of lowering the average cost of resources, reducing SG&A expenses and increase in operating efficiencies.

Financial Vertical

In the September 2023 ended quarter, most US financial institutions reported above consensus estimates of net interest income and earnings despite rising funding costs. With the adverse economic scenario, many large and mid-sized US and European BFS firms are currently focusing on making changes to their operating business model, reducing expenses, and implementing restructuring initiatives. Additionally, these BFS firms have downsized headcounts over the last 12 months and are committed to further workforce reductions in CY24 to control expenses. This would lead to higher cost-takeout opportunities for Indian IT services firms.

The notable divergence between the tech spends growth (+6% YoY) by large global banks and the BFS vertical revenue growth (+1% YoY) of Indian IT services companies for the second consecutive quarter was attributed to accelerated insourcing by some BFS firms which is expected to turnaround due to complex transformation.

Weakness likely to continue in 2HFY24

Commentaries of IT services companies in September-ended quarter indicate that there is no sign of recovery in demand in the near term. Enterprises in this sector continue to face cost pressure due to higher inflation, cost restructuring activities and delay in the monetization of their 5G investments. Enterprises are pulling back on 5G investments and focusing on cost efficiencies. Except HCL Tech, telecom vertical revenue of top-five IT services companies declined owing to weak demand environment, client-specific issues, cancellation of projects, delay in decision making and discretionary spend rationalization by telecom clients. Rising focus on cost efficiencies, cut in discretionary spends and downsizing of headcounts by telecom companies will impact the growth of telecom vertical of IT services companies in 2HFY24.

Summary

Pros

• Despite the delay in automation spending, deal wins remained strong during the quarter. Many Indian IT service companies reported the highest-ever order book despite the lack of near-term visibility.
• The attrition rate has dropped as we see some easing on the supply side. This would help IT service companies improve their operating margins.
• Subcontractor costs are likely to weaken as demand weakens, which should have a positive impact on operating margins.

Cons

• Growth visibility is likely to remain under pressure as the slowdown negatively impacts overall business activity.
• Delayed decisions have weakened revenue growth momentum, even if the deal wins remain resilient.
• Higher onsite expenses and rising costs have negatively impacted operating margins.
• Lack of visibility caused IT providers to slow down the hiring process, which impacted future revenue growth momentum.

Outlook

• After strong revenue growth momentum in FY22 and FY23, it is believed that IT services may face challenges on demand and margin fronts on account of the economic slowdown and macroeconomic uncertainties. There is hawkish near-term outlook for North America (~40% of revenue).

• Deal wins remained resilient even during the difficult times, which gives us confidence that automation spending will rebound strongly in two to three quarters. Demand in industries such as retail and manufacturing remain strong and is expected to regain momentum in the near future.

• Demand for newer technology services such as generative AI, machine learning, IoT, and cloud transformations remains stable and is likely to recover more quickly as certain macroeconomic challenges subside.
• It is expected that most IT services companies will regain momentum in the second half of the year as deal wins remain resilient and supply-side challenges ease. Many companies are becoming increasingly system-oriented and are unable to escape the costs of automation, thereby creating strong long-term demand.

Best Regards,

Alpha Research Team