Earnings preview: Q2 to be another washout quarter for IT sector, market to focus on execution

• The second quarter has always been a historically strong quarter, but Q2 FY24 is expected to be soft.
• The demand picture is still weak and for most sectors, the slowdown has not bottomed out.
• Vendor consolidation has led to a few large deal wins by the Big 3, but conversion to revenues will be slow.
• Margin expansion will also be tough with a stable Rupee and cost levers yet to kick in.

Little has changed for the Indian IT sector in the last three months. The second quarter earnings are expected to be as muted as the quarter before. IT sector clients are continuing with their budget squeezes, cuts in discretionary spending that’s bringing in less into the companies’ revenue kitty.

Top-tier IT companies are expected to see a 0.8% fall in constant currency revenues to a tad over 1% growth on a quarter-on-quarter basis. At the highest end of the most optimistic expectations is a 1.3% growth. On a year-on-year basis too, most see lower single digit growth or a fall – showing that the fear of recession has taken over the market.

Most analysts expect Infosys to retain its FY24 revenue growth, guidance of 1-3.5%. HCL Tech is widely expected to cut its 6-8% growth projections. Most others are expected to veer towards the lower end of the guidance as the first half remains muted.

Where is the budget flush?

The much awaited budget flush that could have changed the fortunes of the sector is still evasive. “The second quarter of FY24 is likely to be incrementally better than the first quarter. But nowhere close to what most players envisaged at year-beginning. Hopes of finding a bottom in the first half has not materialised, we believe, as project ramp downs/cancellations continue,” says a report by J M Financial.

The second quarter has always been a historically strong quarter. And, this theory is all set to change. “Most of the demand indicators are trailing 10-15% below levels at the beginning of the year and only slightly better than the July lows,” said HDFC Securities.

Across sectors, budget cuts have played out differently. For the key BFSI sector, spend cuts have bottomed out. The recovery however is gradual and may not be visible before FY25, says HSBC. Telecom sector which was one of the worst affected, along with high-tech and retail, could also bottom out in the second quarter.

“We think the spending cuts have been unsustainably aggressive. Hi-tech demand has already started to improve from 2Q. Further, verticals like O&G and manufacturing continue to do well,” says HSBC, which believes that Q2 will see a slight positive growth. It however does not see any major budget flush or V-shaped recovery.

Expected change in Constant Currency Revenues (QoQ)

Company	Kotak	J M Financial	IIFL Securities
TCS	0.5%	1%	1.2%
Infosys	0.6%	1%	1.3%
Wipro	-0.6%	0.8%	-1%
HCL Tech	0.8%	0.8%	1.1%
TechM	0%	-1%	-0.5%

Source: Research reports

Big deals, slow conversion

Budget squeezes led to consolidation, with IT clients going in for mega deals. All the big three made top deal announcements in Q2. Infosys bagged a EUR1.5 billion deal from Liberty Global, in addition to a $454 million deal from Danske Bank.

TCS bagged a £800 million deal from Jaguar Land Rover. It also won a NEST € 810 million deal from NEST. HCL Tech also won a $2.1 billion deal from Verizon. “We believe deal flow has steadied after the transition from discretionary spending-powered short-tenured programs to larger programs fueled by cost take-outs, which have longer sales cycles,” said Kotak Institutional Equities.

These kinds of deal wins are expected to continue and grow through the financial year, as discretionary spending. “While most IT services firms saw a further moderation in year-on-year revenue growth in the June quarter, deal wins accelerated. Since then, the large and mega deal win momentum has quickened, giving us confidence in strong growth for FY25,” said BNP Paribas.

Large deals, however, are spread across five years, and tend to convert slowly into revenues. “Barring re-badging deals, ramp-up and hence revenue conversion of mega deals tend to be long drawn,” says J M Financial.

The most watched metric for the IT sector this season would be Total Contract Value-to-revenue conversion pace. The others would be the extent of compression in the existing book of business, and greater-than-normal furloughs, says a report by Nirmal Bang.

Rupee, salaries & margins

One advantage of a soft macroeconomic environment is Rupee depreciation that adds to the margins of IT companies. Rupee depreciated only by 1% on a quarter-on-quarter basis, adding little to the sectoral margins.

“This slowdown is different. Indian Rupee is relatively stable and Covid-19-led cost rationalisation is still unwinding like travel costs and onshore mix,” says HSBC Global Research.

Margin management is also expected to be tough going forward as the operating environment has turned hard. Unplanned benching due to sudden ramp-downs, shift in revenue mix towards cost-takeout deals and lower growth will add to the pain on the profitability end.

Kotak also expects a marginal decline in the EBIT margin on year-on-year comparison, except TechM where the decline will be sharp. Increase in costs such as travel and back-to-office expenses will hurt. “Cost levers are yet to fully kick in,” the research firm adds.

On the other hand, net hiring has been all but flat for most IT sector companies. Moreso, Infosys, HCL Tech and Wipro have all delayed wage hikes which can help, along with other cost rationalization programmes.