Weak outlook

Growth in the IT sector will remain muted

The information-technology (IT) sector remains under pressure. This is visible in market action, muted second-quarter results, and guidance cuts, as well as the pattern of hiring. Managements are cautious and looking forward to 2024-25 for a rebound in demand. Sector analysts have cited weak global activity and high interest rates as inhibitory factors. The results of the big three firms throw up some broad conclusions, which are likely to be reflected in the forthcoming results and guidance of smaller companies in the sector. IT firms are looking at aggressive cost cuts and cost rationalisation to maintain margins. While mega deals are still closing at a good rate, slower ramp-ups and an unwillingness to spend on discretionary projects make the environment quite challenging. Headcounts reduced by an aggregate 25,000 across Tata Consultancy Services, Infosys, and HCLTech in the past six months. Infosys and HCLTech have cut revenue growth guidance for FY24. TCS missed consensus revenue estimates in the July-September quarter and management commentary indicates the company doesn’t have visibility of demand rebound.

In terms of market action, the Nifty IT index fell by over 4.6 per cent in the past month. On global exchanges, the top 25 global tech firms, including Apple, Microsoft, Amazon, Tencent, Samsung, Oracle, and Accenture, have collectively lost over $600 billion in market capitalisation during the July-September quarter. Despite weak economic activity and high interest rates, tech share prices were buoyed up by developments in artificial intelligence (AI) through the first six months of calendar 2023. But AI-driven enthusiasm has waned after the recent hawkish policy updates from the Federal Reserve and the geopolitical tensions triggered by the Hamas attacks on Israel. Although TCS, HCLTech, and Infosys all reported strong deal wins, they are experiencing slow ramp-ups and weak cash flows from such deals. The big three firms, however, managed to improve operating margins. Infosys also reported good topline growth but much of that growth may be non-recurring, pass-through revenues. Infosys’ reduced guidance on revenue growth implies constant-currency revenues may contract slightly in the second half of the year but the silver lining is that it appears capable of maintaining margins.

Most of the mega deals are driven by cost-optimisation initiatives of clients and while such deals may make headlines they cannot fully compensate for aggregate cutbacks in discretionary spending across industry segments. Making the consensus FY25 estimates will require a rebound in discretionary demand. Margin expansions do indicate, however, that IT services firms still have the headroom to cut costs further, and this is a positive factor. The other positive factor is that the hiring churn and attrition are down, implying lower wage bills and higher productivity per hire. Regionally, the key North American market continues to be weak, while better performance in the European Union is driven by mega deals inspired by a desire for cost cutting. Vertical-wise, growth is being led by manufacturing, health care, and energy. Action in verticals such as banking, financial services and insurance (BFSI); hi-tech; telecom; and retail remains muted.

The slowdown is obviously driven by cyclical factors but some of it may also be structural. Many companies have completed or are close to completing digitisation and migration to Cloud. The IT services industry may have to find new revenue streams even after they ride out this fallow period. In terms of macroeconomic outcomes, weak activity in the IT sector may affect services export earnings at a time when crude oil prices are expected to remain high and increase the import bill.