Indian IT sector gear up for a reality check!

3 Jan 2024 , 11:32 AM

Indian IT sector outperformed broader markets by 4% in 2023 despite a 7% cut in earnings through the year as moderating IT demand was offset by easing supply-side pressures and hopes of lower yields, setting aside the hype around gen-AI. Analysts of IIFL Capital Services believe 2024 could potentially be a year of ebbs and flows as a gradual recovery in IT demand could be challenged by continued uncertainty around developed markets macro, yields and US elections. Hence, analysts of IIFL Capital Services expect sector to grow at 6.7% in FY25 and revert above pre-Covid levels only by FY26. Deflationary pressures on supply will support margins, helping deliver double digit earnings growth. Valuations are 30% above 10yr averages, fully factoring in a rebound in demand and lower yields. Hence, analysts of IIFL Capital Services see limited scope to generate absolute returns in the sector, especially in H1CY24, as slower than expected improvement in demand will lead to time correction. On a relative basis, analysts of IIFL Capital Services recommend staying selective with INFO/PSYS/COFO and avoid turnaround trades (TECHM/WPRO/MPHL) for now. 

Five themes to watch out for in 2024: 

Analysts of IIFL Capital Services highlight five key themes that should be watched and potentially will be most talked about in 2024: 

1) No V-shaped recovery – brace for slow burn: All macro indicators and analysts of IIFL Capital Services analysis of top 300 customers of Indian IT companies suggest marginal improvement in demand rather than a V-shape recovery. 

2) Cost of delivery – time to reset lower: Wage inflation is peaking with slower hiring and lower hikes; analysts of IIFL Capital Services are entering a phase of wage deflation as companies look to reduce cost per employee metric. 

3) New CEOs, new strategies: At least eight companies hired new CEOs recently, laying out new strategies in 2024, potentially leading to higher competitive intensity, especially in large deals. 

4) Acceleration in GCCs – share loss or more offshoring? Pace of addition of GCCs is rising, analysts of IIFL Capital Services believe this is led by higher comfort on offshoring post pandemic rather than market share loss for IT firms. 

5) Gen-AI – more investments, less hype: 

In 2024, analysts of IIFL Capital Services would see actual investments and collaborations materializing while the hype around its catastrophic effect on Indian IT sector will subside. 

IT spending – not denied but delayed for sure: 

Analysts of IIFL Capital Services believe Indian IT will continue to be a beneficiary of the multi-year digital transformation journey. However, pace of recovery will be gradual given the uncertainty around macro and US elections. Hence, analysts of IIFL Capital Services forecast sector revenues to grow at 6.7%/10% CC in FY25/26 vs pre-Covid 5/10-year average at 8%/9% respectively. Supply side should face deflationary pressures even as hiring picks up post a headcount decline in 2023. Sector has faced ~280bps margin compression since FY21, which have bottomed out now. Hence, analysts of IIFL Capital Services forecast 12% PAT Cagr over FY24-26 for the sector. 

Valuations – if past were to be prologue: 

IT sector is trading at 26X on FY25 P/E and is now trading at 30% above the 10yr average of 20X. Analysts of IIFL Capital Services believe these levels are unsustainable, as they expect growth to only gradually improve while the sector is already pricing in a sooner-than expected recovery in IT demand and lower yields. Analysts of IIFL Capital Services cut earnings by up to 5% for their coverage and downgrade four stocks. Nifty IT has given lower returns in H1 vs. H2 in 9 out of last 13 years, suggesting higher optimism at the beginning of the year. Hence, while absolute upside is limited in H1, analysts of IIFL Capital Services suggest staying with firms providing better visibility despite rich valuations (INFO/PSYS/COFO) and believe turnaround trades should be avoided (TECHM/WPRO/MPHL) given muted demand outlook.