While a slowdown was expected in IT firms in the March quarter (Q4FY23), it was far sharper. All large companies missed revenue estimates or were at the lower end of the expectation band. The decline in aggregate revenues led by broad-based weakness across verticals and regions in Q4 suggests that cracks are beginning to emerge, a note by brokerage house Jefferies stated.
Further, the demand uncertainty is unlikely to reverse in H1FY24 and the consensus dollar revenue growth expectations of 7 percent in FY24 need a sharp growth recovery in H2FY24 which seems optimistic, it pointed out.
The brokerage noted that the Indian IT space is 'precariously placed'. Jefferies further added that with earnings risks persisting and the sector still trading at an 8 percent premium to its 10-yr average, it remains selective on the sector with Infosys as its only Buy.
Earnings review
Revenue: The brokerage observed that in Q4FY23, aggregate revenues for top-5 IT firms declined 0.8 percent QoQ in constant currency (cc) terms. This is the first QoQ decline in 11 quarters, which is the key disappointment, noted Jefferies.
"While revenues in Q4 were especially impacted by the sequential decline in Communication and Tech verticals, growth across verticals moderated sequentially. In local currency terms, the Americas and Europe both witnessed de-growth, indicating weakness in both regions. Aggregate growth for mid-sized firms was a bit better than large IT firms though they all disappointed in 4Q. TCS and Coforge disappointed the least while Infosys' reported the weakest results," explained the brokerage.
Margins: The brokerage also mentioned that the aggregate margins for its coverage universe contracted 20 bps QoQ and were 40 bps below expectation, mainly due to revenue miss. Employee cost weighed on margins due to muted growth, while Subcontracting costs and other overheads supported margins, it stated. It also added that margin contraction was due to a 40 bps compression in margins for large-sized firms, partly offset by 100 bps margin expansion for mid-sized firms. All large IT firms disappointed on margins, with TechM and Infosys being the weakest and LTIMindtree driving aggregate margin expansion for mid-sized firms, it informed.
Sector view
The brokerage pointed out that the IT firms continued with cautious commentary on the demand environment, highlighting a cut in discretionary IT spending. While bookings were supported by cost takeout and efficiency deals, revenue growth is being impacted by project deferrals delayed ramp-ups, and project cancellations, it further noted. Also, while Europe seems to be holding better than muted expectations, the worsening sentiment in America was the key negative, said Jefferies.
Furthermore, the brokerage stated that IT firms have turned more cautious on the pricing environment, adding that among verticals, IT firms highlighted weaknesses in Communication, Tech, BFSI, Retail and manufacturing verticals.
Another important point to note, as per the brokerage, was that the aggregate headcount for IT firms declined by 8,000 in 4Q – the second straight quarter of decline – similar to the decline seen in 2020 during Covid.
"Declining headcount along with a pricing outlook suggests sharp moderation in FY24 - also evident from the FY24 revenue growth guidance given by Infosys, HCL Tech, and LTIMindtree. Additionally, IT firms expect a soft 1H, also evident from Wipro's guidance for Q1FY24 of -3 to -1 percent QoQ on a cc basis. A weak exit and a soft H1 imply a tougher ask for H2FY24, which would necessitate large deal wins/ramp-ups - the absence of which could drive disappointments to consensus dollar revenue growth expectations of 7 percent in FY24. Our aggregate FY24 revenue growth is 110 bps below consensus," explained Jefferies.
Strategy
As per the brokerage, a weak Q4 and heightened caution led to a 1-6 percent cut in FY24/25 consensus EPS estimates and the back-ended growth implies further risks to consensus estimates, which could drive further derating.
"Underlying the way we see the business, we see two growth drivers for Infosys. And we are well positioned on both in terms of capabilities and track record. One is on digital transformation, comprising of cloud and other elements and one is on cost efficiency, automation and an additional element, which is on consolidation that comes in through that. We feel comfortable for both of those drivers to work overtime," it rationaled. It has a buy call on the stock with a target price of 1,570, indicating an upside potential of 24 percent. This is the only buy call Jefferies' has in the Indian IT space.
Meanwhile, the brokerage has hold calls on TCS, HCL Tech and Coforge and underperform calls on Wipro, Tech Mahindra, and LTIMindtree.
