Higher furloughs to elongate IT spending winter!: IIFL Capital Services

18 Dec 2023 , 11:09 AM

Analysts of IIFL Capital Services interacted with several Indian IT companies across the market cap spectrum this week, so as to gauge the impact of furloughs in Q3 and if there is any change in the demand environment. Key takeaways: (1) Demand environment remains tepid and the existing business volume growth remains challenging. (2) Furloughs in Q3 are higher than last year for most of the companies, and are exceeding expectations at the beginning of the quarter. (3) Customers remain in a wait-and-watch mode and annual budget cycles could be converted to quarterly budget cycles in CY24. (4) There have been instances of insourcing, given the increased investments into GCCs in India by global customers, which could pose risks to FY25 estimates. (5) Q3 is likely to see the impact of partial or full wage hikes for INFO (rolled out from Nov 1), WPRO (rolled out from Dec 1) and HCLT (rolled out from Oct 1). However, the easing supply side continues to be a tailwind for margins. Nifty IT Index has outperformed the broader markets by 7% YTD, despite a deteriorated growth outlook, posing risk to valuations if spending doesn’t improve. 

No change in demand environment; Q3 to be impacted by higher and more widespread furloughs: 

Indian IT companies continue to see a muted demand environment, as discretionary spends remain under check; ramp-up of previously won deals is taking longer than expected. Volume growth remains challenging, as projects come to an end without adequate renewals. Clients are focussing on cost efficiency initiatives and vendor consolidation opportunities. As such, the slowdown is widespread across verticals but led by Communications, BFSI, Retail and Hi-tech; while Manufacturing and Healthcare are resilient. Most companies that analysts of IIFL Capital Services spoke to are seeing longer and more widespread furloughs vs last year as well as what was expected at the beginning of the quarter. This could put additional pressure on Q3 sequential growth and hence, on achieving FY24 revenue growth guidance. 

Decision-making cycles elongated; no green shoots in sight: 

While mega deal wins have been resilient for Indian IT companies, they continue to see elongated decision-making cycles and slower conversion of deal wins to revenues. Instances of budget flushes have been largely absent. There have also been sporadic instances of insourcing by certain clients, given the high investments that have gone into GCCs (TCS, HCLT, Atos). Some customers are holding back budgets as they wait and watch out for the GenAI use cases to emerge. Initial discussion around CY24 technology budget with customers have limited positive news for Indian IT companies; but more clarity will emerge in Q4FY24. In the current uncertain macro environment, there is a potential for annual technology budgeting exercise to move to a quarterly budget, which could limit the visibility. 

Margins of INFO, WPRO and HCLT to be impacted by wage hikes: 

INFO, WPRO and HCLT have rolled out wage hikes during the current quarter, which is likely to impact Q3 margins. However, the quantum of wage hikes have been lower than the last couple of years. Apart from negative operating leverage from muted growth and the above mentioned wage hikes, there are limited margin headwinds as muted hiring, increasing offshoring and easing supply side continue to be levers for the companies, helping them to arrest sharp declines. 

Valuations rich, given limited visibility on growth outlook: 

Nifty IT is up 25% vs Nifty up 18% YTD, despite seeing high single digit estimate cuts during the year. Since the increase in expectation of potential rate cuts in CY24, Nifty IT has rallied further in anticipation of potential increase in IT spending amid lower yield environment. Nifty IT is now trading at 25x 1YF P/E and mid-caps are trading at over 35% premium to the large caps. At these valuations, analysts of IIFL Capital Services see limited upside potential for the sector and see downside risks to Q3 earnings going into the results. Given sector valuations are rich, they recommend REDUCE on TECHM, WPRO, MPHL given weaker growth profile and poor earnings visibility while valuation have run up. On a relative basis, analysts of IIFL Capital Services prefer INFO/TCS in large caps and PSYS/COFO/CYL in the midcaps.