No signs of demand improvement yet; reduce Wipro, sell TechM, ICICI Securities

Based on our discussion with IT company managements ahead of their silent period, we haven’t observed any significant change in their demand commentary over the last 3 months.

Due to macro headwinds in key industry verticals like banking and hi-tech, and in key geographies like US and Europe with persistently high interest rates and inflationary pressure, discretionary technology demand is getting delayed. There is higher level of scrutiny around each deal due to which pipeline to conversion is taking longer than usual and in certain cases orderbook to revenue conversion is also slow. Accenture’s recent quarterly result (link) also indicates smaller deals around digital transformation and consulting are drying up and focus is higher on larger cost optimisation deals. In such a scenario, we believe the duration of contracts would increase with slower conversion of orderbook to revenue. We see heightened risk to the top end of Indian IT companies’ revenue growth guidance for FY24E due to the following key reasons:

• Accenture’s weak growth guidance for Aug’23 quarter implies no immediate demand revival and Sep’23 quarter growth for Indian IT companies could also remain weak, contrary to the street and company managements’ expectations of demand revival post Jun’23.
• Multiple cancelled or postponed projects during Mar’23 quarter haven’t seen the light of the day with limited visibility of them getting executed in near- to -medium term.
• Post covid, multiple enterprises have sped up their technology initiatives around cloud to enable virtualisation and digital transformation. With employees returning to offices and the profitability for enterprises coming under pressure due to inflation, there is now heightened level of scrutiny around technology budgets with multiple discretionary projects having limited RoI visibility getting permanently cancelled or postponed.
• Signs of increasing pricing pressure as contribution of cost optimisation deals in overall order book and revenue is increasing, wherein competition is high and margins could be lower in the initial stages of deal ramp ups.
• There may be negative impact of generative AI on IT services contract pricing in the near term, which is yet to be clearly established but has high probability of playing out over the next 1-2 years, similar to the initial deflationary impact of cloud and SaaS during 2015-17 period. A couple of projects around application development, maintenance, testing, BPO and customer support may get further automated. Amid slowing demand environment with high competition, there could be predatory pricing carried out by few IT service companies that are ahead in technology adoption curve, thereby, enabling them to accelerate their market share gains.

We cut our FY24-26E EPS estimates by up to 6% on the back of weak Q1FY24 and weakerthan-expected Q2 Due to soft demand outlook with limited large deal ramp ups during Q1FY24, we expect QoQ revenue growth in CC terms for our coverage companies to be in the range of -2.4% (TechM) to +4% (Happiest Minds). Our BUY rated TCS, INFY and Persistent are expected to grow at 0.2%, 0.8% and 3% QoQ in CC terms, respectively. On the other hand, our SELL rated TechM would have the weakest sequential revenue growth at -2.4% in CC terms due to sharp weakness in communication, media and entertainment verticals along with soft orderbook. REDUCE rated Wipro is likely to grow its revenue at -1.6% QoQ CC. We expect EBIT margins to be largely flat for most IT companies except TCS, which has announced wage hike starting Apr 1, ’23.

We turn cautious on the Indian IT services sector for the near (3-6 months) term given there could be downside risks to consensus earnings forecasts for Q1/Q2FY24E and FY24E with macro headwinds continuing to persist at least for the next few quarters. In terms of valuations, NIFTY IT is currently trading at 21X 1-yr forward P/E multiple compared to its last 15-yr average of 18X and factoring in demand pick up in FY25E given the structural tailwinds around cloud migration and digitalisation for the sector. For medium- to -long term (1-2 years), we believe investors should add high quality names like TCS, INFY and Persistent that are building strong partnerships with key technology players globally, have consistent strong management execution, ability to win large cost optimisation deals during weak macros and have laser focus to harp on the digital transformation opportunity for its clients.

Infosys: We expect Infosys to report soft 0.8% QoQ growth in CC terms Q1FY24E. With 20bps cross currency tailwind, this would imply muted 3.5% YoY growth in US$ terms. With our expectation of pick up in growth only in H2FY24E as Q2 may also remain relatively soft at 2.7% QoQ CC growth given no mega deal ramp ups in Q2; we believe INFY could narrow its revenue growth guidance to 4-6% in CC terms for FY24 from 4-7%. We are now expecting 5.1% CC growth for INFY in FY24E with EBIT margin at 21%. With the stock currently trading at 18.4X FY25E (same as last 15-yr avg), we see attractive risk-reward for INFY with the expectation of 12.8%/12.4% CC revenue growth in FY25E/26E given its superior digital capabilities, strong partner ecosystem and management execution. Our 12-month target price of Rs1,613 implies 24% potential upside and we reiterate our BUY rating on INFY. Mega deal announcements similar to the recent ones like with Danske Bank would be the key catalyst for stock re-rating providing a smooth path for sequential pick up in H2FY24E and double digit revenue growth in FY25E. Key risks: Delay in mega deal announcements, ramp-ups due to adverse macro environment.

HCL Tech: We expect HCL Tech to report weak Q1FY24E with flattish growth QoQ CC given the pressure in ER&D vertical and weak seasonality in IT services segment in any June quarter due to annual productivity benefits passed on to certain large customers. We now expect HCLT to report 6.5% YoY CC revenue growth in FY24E, at the lower end of its revenue growth guidance of 6-8%. We expect its EBIT margin at 18.1%, 10bps lower QoQ due to limited operating leverage and no wage hikes in Q1FY24. We have ADD rating on HCLT with 9% potential upside given it is likely to be the fastest growing IT services company among its large cap peers in FY24E. With stock trading at 17.5X FY25E, at a significant premium to its last 15-yr average of 14.6X, we see limited further re-rating potential in HCL Tech.

Wipro: We expect Wipro to report revenue growth of -1.6% QoQ CC for IT services segment against the guidance of -1 to -3% in Q1FY24E given the continued weakness in its banking and consulting business. For Q2FY24E, we expect muted 0-2% QoQ CC revenue growth guidance given there are no mega deal announcements and no signs of incremental demand pick up in Wipro’s key banking and retail verticals that have been its primary growth drivers in the past.

For full report, https://www.communicationstoday.co.in/wp-content/uploads/2023/07/Technology_Q1FY24_Preview1.pdf

CT Bureau