Is the glass half full for Tier 1 IT firms?

In a breather of sorts, the December quarter (Q3FY24) results of tier 1 IT companies released so far, were not as bad as feared. The sequential constant currency (CC) revenue performance of Tata Consultancy Services (TCS), Infosys, HCL Technologies and were better than estimates. Expectations were low as Q3 is a seasonally weak quarter due to furloughs coupled with the ongoing demand uncertainty.

Notably, management commentary is still cautious with large caps not seeing a visible pick up in discretionary IT demand just yet. Cost optimization projects continue to drive the deal momentum. For instance, Infosys’s management said the number of digital programmes in the deal pipeline is low, whereas the number of cost takeout and vendor consolidation programmes is relatively higher.

Clients are focusing on conserving cash, thus leading to a delay in decision making and project deferrals. This means that a faster conversion of deals into meaningful revenue growth isn’t on the cards in the near term. Small wonder then Infosys tightened its FY24 CC revenue growth guidance from 1 2.5% year on year to 1.5 2%.

HCL narrowed its overall FY24 CC growth guidance from 5 6% earlier to 5 5.5%. Wipro has guided for a 1.5% to 0.5% QoQ CC growth in IT Services for Q4, which is lower than some analysts’ estimates. Despite mixed signals, the sharp up move of IT companies’ shares suggests investors are latching on to the positives of Q3 results, overlooking likely downside risks.

On Friday, shares of TCS and Infosys rose nearly 4% and 8%. In a positive rub off effect, HCL and Wipro stocks gained almost 4% each ahead of Q3 earnings that were out after market hours. Wide held expectations of potential interest rate cuts by the US Federal Reserve in 2024 is fuelling hopes of turnaround in discretionary IT spending of the BFSI industry—a crucial demand driver for the IT sector.

But note that large cap IT companies saw a drop in hiring in Q3FY24—a sign of muted demand. Adding to the caution is the senior level exits that some are seeing. Sure, the focus on cost optimization has continued, aiding operating performance, but that alone is not enough to justify the Street’s gung ho sentiment.

According to Jefferies India, Wipro’s Q3FY24 results beat estimates mainly led by higher margins, but Wipro’s demand commentary is very different from Accenture which has a sizable consulting business. “Moreover, none of the IT firms that have reported in Q3 have called out an improvement in demand environment," it said, adding, Wipro’s declining employee headcount does not inspire confidence on a sharp growth recovery.

Now, between the Street’s optimism and poor revenue visibility, the question is whether the worst is behind for the sector. There are no easy answers for this. A lot depends on the economic scenario in the US. But if the global macro environment doesn’t deteriorate further then earnings may start seeing meaningful upgrades post H2FY25.

However, if rate cut hopes don’t materialize then investors can be disappointed. The consensus is underestimating growth and margin risks in FY25 as it did in FY24, according to Nirmal Bang Institutional Equities. In a report on 12 January, it said, “While digital transformation services will continue to be a key theme over the medium term, we believe IT spends will be curtailed by an ‘ability to spend’ problem as enterprise customers battle earnings pressure from wage inflation, reduced end customer spending power, higher interest rates and likely below trend growth in western developed economies." So, valuations are not a big comfort.

Shares of tier 1 IT companies trade at FY25 price to earnings of 20 27 times, showed Bloomberg data..