Cautious optimism, but no clear green shoots in Indian IT sector: IIFL Capital Services

12 Jan 2024 , 12:04 PM

TCS and Infosys Q3FY24 results reaffirmed analysts of IIFL Capital Services view (2024 Outlook) that 2024 could potentially be a year where the pace of recovery will be gradual, given the macro uncertainty and US elections. While TCS delivered slightly better revenue growth (+1% CC QoQ) helped by the BSNL deal ramp-up, INFO’s revenues (-1% CC QoQ) were also in-line. Both companies surprised on margins. Deals were strong for INFO, but modest for TCS. Key takeaways: (1) Demand remained muted with growth visible in Manufacturing, Healthcare and E&U verticals only. (2) Pass-through revenues potentially contributed heavily in Q3, as third-party hardware/software costs rose by 82%/23% YoY for TCS/INFO respectively. (3) While mega deals were fewer, both companies indicated a strong deal pipeline. (4) Headcount decline continued at ~6K each — a sign of muted near-term outlook; attrition came off further with INFO now at lower rate than TCS. (5) Margins surprised on easing supply side and cost-saving programs, and may see continuous improvement through 2024. Analysts of IIFL Capital Services believe these results reaffirm muted growth outlook for the sector with margin tailwinds. Sector valuations are 30% above 10yr averages, fully factoring in a rebound in demand. Analysts of IIFL Capital Services prefer INFO over TCS, given more attractive valuations and potentially better growth visibility in FY25. 

TCS: Solid margin execution: 

While TCS revenues (1% QoQ cc) were better than expectations, these were potentially boosted by ramp-up of the BSNL deal (India +25.7% QoQ), which will continue to ramp up for the next four to six quarters. Margins (+80bps QoQ) were in line with IIFLe, due to lower subcontracting and headcount (-1% QoQ). Growth was visible in Manufacturing, Healthcare and E&U while BFSI, Retail and TMT continued to decline. Management indicated potential uptick in BFSI from Q4 onwards and strong deal pipeline, despite a modest US$8.1bn of deal wins (+4% YoY, +12% TTM YoY) with no mega deal wins. LTM attrition dropped further to 13.3% (-160bps QoQ) on continued easing of supply side; while headcount was down. 

INFO: Solid deal wins: 

INFO’s Q3 revenue decline of 1% CC QoQ was impacted by sharp decline in Retail, Healthcare and hi-tech segments. At 20.5%, margins were managed well despite the two months’ impact of wage hikes (-70bps) and one-off costs from McCamish cyber-attack incident (-60bps); partially offset by benefits from Project Maximus. INFO narrowed down FY24 revenue growth guidance to 1.5-2% YoY, implying -2% to 0% QoQ in Q4. At US$3.2bn (+53% TTM YoY, 71% new), large deal wins added on to the already-swelling revenue backlog for FY25. Attrition dropped further to 12.9% (-170bps QoQ), while hiring continued to decline by ~6k (-7% YoY). 

IT spending: Not denied, but delayed for sure: 

Analysts of IIFL Capital Services believe that the pace of IT spending recovery will be gradual, given the macro uncertainty. Hence, analysts of IIFL Capital Services forecast sector revenues to grow at 6.7%/10% CC in FY25/26 vs pre-Covid 10yr average at 9%. Supply side should face deflationary pressures even as hiring picks up post a headcount decline in 2023. At 26X FY25 P/E, the IT sector is trading at 30% above 10yr average; which analysts of IIFL Capital Services believe is unsustainable as the sector is already pricing in a sooner-than-expected recovery in IT demand.