Q2 earnings expected to make limited waves for IT
If you are looking for fireworks in the September quarter earnings (Q2FY24), then don’t look at the information technology (IT) sector. The narrative for the second quarter (Q2) has not changed much versus the recent quarters. Technology companies are poised to clock muted revenue growth despite a robust deal pipeline. Slower-than-anticipated ramp-up or conversions of existing deals would cap a sharp revival in revenues in the near future.
Mid-cap IT stocks are expected to continue to beat large-caps in revenue growth, though the tepid demand scenario has reduced this differential lately. Analysts from Nomura Financial Advisory and Securities (India) expect large caps to report quarter-on-quarter constant currency revenue growth ranging from -1% to +2%. The brokerage expects midcaps to report growth ranging from 0.7% to 3.3%.
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The margin performance is expected to be a mixed bag in the second quarter. Ebit margin movement could vary widely across companies sequentially depending on their wage hike cycles. Ebit is earnings before interest and tax; a measure of profitability.
“Variable compensation levels will influence quarterly margins across companies. For example, we expect Tech Mahindra Ltd to increase variable compensation payout for senior leadership, which will impact margins. We do not expect any change in Infosys’s variable compensation,” said analysts at Kotak Institutional Equities in a 29 September report.
To be sure, easing supply side pressure is a bright spot for margins, but that alone may not be enough to drive significant margin growth in the current backdrop. The villain is the same. Delayed client spending or rationalization on discretionary IT projects due to looming concerns about a slowdown in global growth continues to cloud the sector’s revenue visibility in FY24/FY25. IT companies with a large number of clients in the retail and telecom sectors could feel more heat on revenue growth as clients in developed markets struggle with high inflation.
Further, a twist in the tale could now come from increased caution among clients on smaller deals. The management of global IT giant Accenture highlighted this emerging pain point in its latest earnings commentary. If this were to play out for Indian technology companies, then it would be an incremental negative for mid-cap IT companies which depend more on short-cycle deals.
Who is the hero then? Cost takeout deals that aid optimizing expenses in a business are in demand and can drive deal win momentum for the sector in Q2. The management commentaries on deal pipeline and client budgets will be crucial to gauge the sector’s growth prospects. Moreover, any downward revisions in FY24 revenue growth guidance by Infosys Ltd and HCL Technologies Ltd would hit investor expectations. After all, the hope of revenue recovery in H2FY24 has translated into 11% gains in the Nifty IT index so far in 2023.
Sure, valuations of IT stocks have moderated from the elevated levels seen last year, but that alone is not sufficient, given the lack of clarity on revenue outlook. “Our recent interactions with IT firms and Accenture’s tepid guidance suggest that demand uncertainty persists and a recovery is still not in sight. Given this, we believe that consensus estimates of 8%+ USD revenue growth in FY25 (+80 basis points versus our estimates) are at risk,” said a Jefferies India report on 30 September. “We believe that the sector’s valuation at 24x price-to-earnings—a 20% premium to 10-year average and 28% premium to Nifty—is rich,” it said.
To conclude, Q2 which is usually a seasonally strong quarter for the sector, may be nothing to write home about.
