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IT Sector – Cut FY25 estimates, sell into FOMO rally, Nirmal Bang

Nifty-IT has outperformed Nifty by ~630 basis points year-to-date-2023 (830 basis points quarter-to-date) after underperforming by ~3000 bps in 2022. We believe market is taking the view that the worst is over and that revenue/earnings will accelerate sharply in FY25. We have a non-consensus view that FY25 growth is going to be only a tad faster than FY24 with risks that it could be as bad or weaker. While U.S. macro has surprised positively in 2023 so far, deterioration is likely ahead in 2024. We have cut FY25 estimates (flagged off multiple times in our earlier notes) for much of our coverage. Demand is likely to be slower for longer.

We remain ‘underweight’ Indian IT services sector, which has seen price-to-earning multiple expansion (especially for tier-II) in the last six/12 months with no meaningful earnings upgrades. While we have a ‘Sell’ on most of our coverage, we have upgraded Tech Mahindra Ltd. to ‘Accumulate’ as we feel that margin expansion in FY26 may surprise on the upside under a new management.

Post two successive quarters of weak results (in aggregate), we believe that Q2 FY24 and Q3 FY24 may see QoQ growth for our coverage universe, but the next couple of quarters’ performance will not herald the beginning of a sustained pick-up. We see growth discontinuity in 2024.

Macro uncertainty has led to weak spending by customers. That uncertainty we believe has accentuated over 2023 if one looks at broader data points (see our analysis inside) than just the U.S. real GDP growth. The U.S.’ resilience has been driven by consumers and higher fiscal deficit. The consumer could as a drag in 2024. Europe and China seem to be in a soft patch of their own.

Over the last 12 months while order pipeline/inflow has been good, growth has been weak due to weak discretionary spend, weak revenue conversion of total contract value won and compression of the existing book of business (with low visibility to external world). We think the next phase of weakness in 2024 will likely see pipeline/TCV compression with more generalised pricing pressure (unlike the sporadic one currently).

A look at enterprise health (based on consensus revenue/earnings forecasts for S&P 500 and STOXX 600 indices and sub-indices) across both the U.S. as well as Europe points to improvement, especially since June 2023. We see a mixed picture at the sub-indices level, but believe that consensus will cut estimates in 2024 like it did in 2022/2023

Downward guidance revisions by multiple players (some despite a robust H1 2023) in the last three months imply a weak H2 2023 in aggregate. There has not been much commentary on 2024, although a few are hopeful of an upturn. We believe the next big trigger to be Accenture’s organic growth guidance for FY24 (year ending August), which we think will likely be ~1-4%.

On margins, we disagree with consensus that they will improve over FY24-FY26. The mega deals we believe are fiercely competed (‘priced to win’) and believe are dilutive not only in initial years but are dependent on extraction of significant productivity gains and operational efficiencies, where companies may fall short.


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