IT Firms: Mind The Bend

ON OCTOBER 12, when Bengaluru-headquartered Infosys declared its Q2 FY24 results, the company restated its annual revenue growth guidance to 1-2.5%. In successive quarters since the beginning of the year, the IT major has tweaked the number. At the beginning of FY24, Infosys had estimated a revenue growth of 4-7%, which after the end of the first quarter, was reduced to 1-3.5%.

On the same day (October 12), Noida-headquartered HCL Tech, which also declared its second-quarter numbers, put its full-year growth guidance at 5-6 %, down from 6-8% earlier.

Two of the three largest Indian IT services companies by market cap and revenue (TCS does not provide annual revenue guidance) have turned bearish this year on weakening demand in the U.S. and Europe, which form the backbone of their revenues. While good deal wins seem to be the silver lining, management commentaries signal uncertainties ahead. Companies' approach, meanwhile, has been defensive — tweaking manpower costs and saving expenses to protect profitability.

Demand Slowdown

The first six months of a fiscal, traditionally considered the two strongest quarters for most companies in the information technology space, have turned out to be rather bleak. India's largest IT services company Tata Consultancy Services, the first to declare its quarterly revenue numbers earlier in October, set a somber tone for the earnings season. Its sequential revenues fell by a marginal -0.2% to $7.2 billion in Q2FY24. On adding just under $780 million in additional revenue in the last six months, CEO and MD K. Krithivasan says clients are being more cautious given the current macro environment, and the spending priority has moved from discretionary areas to cost optimisation. "This is driving significant momentum towards large outsourcing deals, vendor consolidation and operating model transformations," Krithivasan says during an investor call.

While TCS does not provide annual revenue guidance, two of its competitors — Infosys and HCLTech — have revised it downwards this quarter. Infosys, which posted a 2.2% sequential growth in Q2, cautioned on growth, by further reducing the top end of its revenue guidance for FY24. The rationale given by Salil Parekh, MD and CEO was, "With the continued reduction in digital transformation programmes and discretionary spend and the ramp-up of large and mega deals towards the end of the financial year, we are changing our growth guidance for this fiscal to 1-2.5% in constant currency terms."

Meanwhile, HCL Technologies, which announced the acquisition of German ASAP Group (an automotive engineering services provider) in May this year, posted a sequential growth of 0.8%. With revenues of $3.2 billion in Q2, the company expects "healthy growth" in the second half of the fiscal year. "While we have won some large deals and have been successful in gaining share on cost optimisation-led deals, the market is still weak on discretionary spend. At the start of the year, we had expected it to come back at least partially by now, but given the macros, it has not yet come back," says C. Vijayakumar, MD and CEO. For the entire year, minus the acquisition, HCL Tech has indicated its growth at 4.5% to 5.5% organically for services, and the overall guidance has been brought down to 5-6%, from the earlier 6-8%.

Kotak Institutional Equities, in a report dated October 16 on these three companies, points to three major themes. First, the companies have gone for aggressive cost cuts, weeding out inefficiencies, which they were earlier comfortable with. Second, the mega deals closed will be important in these times (large deal buckets for TCS, Infosys and HCL, respectively). And third, the visibility of improvement in discretionary spending is still bleak. Based on these factors, the brokerage expects a 2-3% contribution in FY25 from the mega deals signed recently for these companies. With clients slowing down on discretionary spends, the report notes, "CY2024 budgets will be cleaner and clients will continue to spend on the digital transformation journey. On the macro front, our base case is a slow-growth environment and not a recession," something that is likely to bring some comfort to investors.

The trend is no different for other companies as well, in fact worse for some. Wipro posted revenues of $2.7 billion in Q2FY24, a 2.4% dip sequentially. With a seasonally weak quarter ahead and the company running the risk of a full-year revenue decline, CEO and MD Thierry Delaporte says in an investor call, "Lower discretionary spending is a reality today. Conversion of order-books has become slower. Transformation programmes that are nearing the project term are being replaced by new ones, but at a slower pace." TechM with $1.5 billion in revenue, and a sequential revenue dip of 2.8% in Q4FY24, reported one of its worst quarters. It also saw a staggering sequential decline in its revenues from major clients, down 7.2% from the top five, and 3.7 from the top 10.

As discretionary demand takes a hit, the outlook for banking, financial services and insurance (BFSI) remains bleak, according to Nomura research report. BFSI constitutes nearly a third of the revenues for most IT companies. In a report dated October 9, Nomura says given the current 'sticky' high inflation and labour shortage in developed markets, cost take-out deals might continue to come by. It expects large-cap Indian IT companies' revenue growth to increase from 3.2% in FY24 to 8.2% in FY25.

Cost Control

While growth outlook might be weak, most companies haven't changed their margin outlook for the year. For instance, both Infosys and HCL have maintained their FY24 operating margin guidance unchanged at 20-22% and 18-19%, respectively. As revenue growth looks weak, several of them are actually expanding it. TCS, which recorded an operating margin of 24.3%, saw a 110 basis point (bps) expansion sequentially, which came from improved utilisation, productivity and optimisation of subcontractor expenses. Infosys' Q2 operating margin at 21.2% was an improvement of 40 bps. The company has already embarked on Project Maximus, a margin improvement programme. "We have also seen some early benefits in areas such as utilisation and optimisation of overheads," says CFO Nilanjan Roy. HCL, on the other hand, saw a 154 bps improvement in operating margins at 18.5%, compared with 17% last quarter, driven by efficiencies in managed services operations through automation and artificial intelligence.

Analysts at Kotak see adequate levers for margin improvement over the medium term for Indian IT's top three. "We build in 60-110 bps margin expansion over FY24-26E for TCS, Infosys and HCLTech," according to the report.

While subcontracting costs are seeing a downward trend and firms are looking to improve utilisation rates, Indian IT firms have so far been managing costs aggressively in FY24 through low hiring and lower-than-usual salary increases, according to Nomura. In fact, staffing firm Teamlease, in July, had sounded out a muted demand environment in the sector. The company, which caters to IT services under its specialised staffing segment, says budget constraints were affecting corporate training programmes. In fact, in the last six months, the top five companies with the maximum headcount (TCS, Infosys, Wipro, HCLTech, LTIMindtree) have collectively seen the figure drop by nearly 34,000 employees compared to the first half of last fiscal year (H1 FY23). Coming on the back of strong headcount additions in the past fiscals, TCS has hired less than its attrition rate in Q2FY24, and HCL is likely to fill some of it with trained freshers. Wipro, on the other hand, may not be hitting campuses for freshers this fiscal.

With the second half of the fiscal also witnessing furloughs and holidays and fewer billing dates, most analysts think FY24 will be a washout year. But will FY25 be better? While mega deal wins might bring some tailwind, we are still a few months away for a clearer picture to emerge.