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IT sector – Too early to be positive

It is too early for the IT sector to be positive, FY25 estimates are at risk if the US recession happens in 2024, says a Nirmal Bang report. “We continue to remain cautious on the IT sector with an underweight stance and will wait for better valuations or evidence that the worst is behind us. Only capitulation by the U.S. consumer would in our view signal that we are close to the end of the current cycle of pain. The precise timing of this is unknown.

Management commentary/data points across global IT Services players and cloud/software-as-a-service players in the June 2023 quarter-to-date as well as from the recent meetings we have had in Bengaluru with a few tier-I players suggest that the June 2023 quarter is likely to be weak for tier-I players as has been widely expected.

The situation for tier-II players will be much more company specific. However, customer health (2023 S&P 500 consensus profit being the proxy) has improved with the March 2023 results season being better than expected. This has been driven more by Ebitda margin expansion than sales growth.

It remains to be seen if customer health continues to improve further, inducing a pick-up in discretionary spending by enterprise customers in H2 2023 or they would continue to remain cautious in anticipation of the much-expected U.S. recession.

There have been mixed responses from IT services players to the question ‘whether customers have frozen their spending plans for 2023 at the current weak levels and will only relook at them in early 2024?’.

Discretionary demand commentary by select players indicates that the H2 FY24 revival narrative (involving some steep QoQ growth) may be at risk.” leading to further FY24 guidance/consensus downgrades (‘discretionary’ is dependent on client context but should broadly be equated with ‘Digital’).

We have modestly tweaked earnings per share estimates downwards for select players in this note from already below consensus levels. Our FY24 estimates assume a weak Q1 FY24 for most tier-I players with a weak pick-up in compound quarter growth rate over the rest of FY24.

Despite areas that seem to be in pain, the U.S. economy continues to be resilient on the back of a rather strong consumer and services sectors (constituting 70-80% of gross domestic product).

The continued strong employment and high and sticky core inflation data seem to indicate that U.S. interest rates will at least remain elevated (if not go higher) for a longer period than expected.

It looks as though the much-expected slowdown/recession is a late 2023/H1 2024 event. If that were to happen, we believe that U.S. enterprise customers will continue to experience uncertainty for a longer period, leading to continued weak discretionary spending and industry growth would then be ‘slower for longer’.

This means that the sharp revenue growth pick-up that consensus (including us) is building in for FY25 may be at risk. BQ Prime

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