On Tuesday, the Nifty IT index fell 1.76 percent to 28957.15 points after global brokerage firm JP Morgan downgraded all of its "overweight" stocks in the IT sector to "neutral" and maintained its "underweight" position in the sector.
Results Review: Major IT firms have not raised their revenue guidance for FY23; Is that a red-flag?
JP Morgan advised investors to sell into the recent rally in shares of information technology companies, citing high valuations and margin pressure.
Jefferies noted that over the past 20 years, US real GDP growth has fallen to 0% twice, and in both cases, global IT services spending has seen marked growth moderation.
On the other hand, domestic brokerage firm Edelweiss Securities, too, has slashed target PE multiples of all IT stocks in its coverage.
ICICI Securities said IT companies reported a miss on margins and largely in-line revenues, with the exception of Infosys, MTCL, and Tata Elxsi in Q1FY23.
In the last week alone, the Nifty IT index has dropped 4.70% after minutes from the July 26-27 meeting revealed that Federal Reserve officials maintained their hawkish stance and were committed to returning inflation to the 2% target.
The index has dropped approximately 10,050 points since the beginning of the year, falling to 28,608 from 38,658 and losing nearly 26 percent of its value. Further, the IT index has dropped 27.47% from a record high of 39,446.70.
In 2021, the Nifty IT index increased by 59 percent, owing to substantial earnings growth for IT companies as a result of digital transformation transactions in the United States and Europe.
High operating costs hit margins in Q1FY23
The June quarter results were harmed by high attrition levels, as well as higher-than-normal wage increases, hiring costs, and sub-con costs.
The June quarter witnessed an increase in attrition rates for most IT companies in the range of 30–350bps. This is largely due to a talent crunch and elevated demand for niche skills, said ICICI securities.
Companies, on the other hand, stated that quarterly annualized attrition rates have decreased and that they expect the curve to stabilize in the near future.
However, ICICI Securities believes it is likely to stay elevated as past trends suggest attrition is usually higher in a post-wage hike quarter.
Tata Elxsi reported a strong beat on both revenue growth and margins. Wipro negatively surprised the street with new low in EBIT margins (declined 200bps QoQ to 15%) even before wage revision.
Wipro Ltd reported a 20.6 percent year-on-year decline in consolidated net profit at ₹2,563.6 crore for the quarter ended June, owing to higher employee costs that pushed up overall expenses. Wipro's total expenses increased by 22.9% to ₹18,648 crore.
Similarly, TCS’ total expenditure during the June 2022 quarter jumped 19.95 percent to Rs.40,572 crore, compared with Rs.33,823 crore in the corresponding period last year. Its employee costs increased by 18.23% to ₹30,327 crore from ₹25,649 crore.
TCS reported an operating margin of 23.1% in the June quarter, 190 basis points lower than a year ago and 240 basis points lower than the previous quarter. According to TCS CFO Samir Seksaria, the dollar's strength against most currencies increased margins by 25 basis points. But all that was negated by the increase in wage costs, TOI reported.
Infosys reported a lower-than-expected 3.2 percent increase in net profit for the June quarter as operating margins declined due to rising expenses. Profit fell 5.7 percent sequentially from ₹5,686 crore in the January-March quarter. In the first quarter, the operating margin fell to 20.1 percent.
Meanwhile, HCL's operating margin for the April-June quarter fell 90 basis points sequentially to 17%, dragged down by increased travel and manpower costs amid all-time high attrition in the services business.
Softness in deal TCVs
The June quarter witnessed a sequential decline in deal wins across IT companies barring Mindtree (+46.2% QoQ US$) and Coforge (+4.7% QoQ US$). witnessed a sequential decline in deal wins across IT companies barring Mindtree (+46.2% QoQ US$) and Coforge (+4.7% QoQ US$), data from the ICICI securities report showed.
HCL reported healthy growth of 23.4% YoY US$ backed by large deals. Further, Mphasis indicated a slower conversion of TCVs to revenue in Europe. While Coforge continued to win large deals, owing to its laser-like focus on proactively pursuing large deals.
A few retailers in the US have cautioned about a higher-than-expected reduction in profits, and thus may reduce their tech spending, ICICI Securities noted.
Management commentary around demand and the deal pipeline remained strong as macro concerns have not yet been reflected in client conversions, leading to them retaining revenue guidance for FY23. However, management remains cautious about worsening macro, and as a result, they have not raised their revenue guidance as they did last year when demand was very strong.
The brokerage firm said Infosys is an exception, having raised its revenue guidance to 14-16% YoY CC (from 13-15%) due to strong growth in Q1FY23 and healthy deal TCV.
It expects growth to be the front end for Infosys. Further, most companies have retained their margin guidance after lowering it in the last quarter. HCL guided for margins to be at the lower end of its band.
Cut in staff bonuses and variable pay
Amid a margin squeeze and high employee costs, India's second-largest IT firm, Infosys, has scaled back the average variable payout of employees.
Infosys has reduced variable payout for the June quarter to about 70 percent and the employees have been informed about the same.
Earlier, Wipro told their employees they had reduced the variable pay portion of employee compensation, according to respective internal emails sent by management to staff at the two companies and seen by Reuters.
On the other hand, Tata Consultancy Services has reportedly delayed the quarterly variable compensation payout for some employees by a month.
Indian IT firms are worried about the budget tightening from their US and European clients, who are currently bracing for recession.
In May, Goldman Sachs said that there is a 30% chance that the US economy will enter a recession over the next two years as a result of the US Federal Reserve's aggressive interest rate hikes. Others, such as Well Fargo and Morgan Stanley, believe a recession in the US is around the corner as the Fed shows no signs of easing its fight against multi-decade high inflation.
Besides the US, the European market is also feared to be heading into a recession as the Ukraine-Russia war, soaring energy prices, and prospects of higher interest rates push the EU to the brink of a recession over the next two years.
The European and US markets are very crucial for the Indian IT industry as they account for 70% of revenues for the big five—Tata Consultancy Services, Infosys, Wipro, HCL Technologies, and Tech Mahindra—accounting for more than half.
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