Disappointing numbers

IT sector has hit a rough patch

Disappointing results and pessimistic guidance from Tata Consultancy Services (TCS) and Infosys have spooked investors across the IT services sector. There has been a sharp sell-off across IT stocks, including those that have not yet delivered their Q4 (January-March 2023) results. The Nifty IT index declined by 4.7 per cent on Monday as every stock in the index lost at least 1.5 per cent, and the biggest loser, Infosys, was down by over 9 per cent. While this may seem like an over-reaction, there’s consensus FY24 will see little if any revenue growth across the industry, and earnings estimates are being broadly downgraded. Given this scenario, investors are also likely to reduce valuation multiples. 

A few broad trends are apparent. Going by geography, North America (which contributes roughly two-thirds of industry revenues) saw the softest revenue trends, and the banking, financial services and insurance (BFSI) vertical witnessed the deepest contraction, while growth in other verticals was largely flat. BFSI is a key vertical for most IT services companies and is by far the single-largest contributor to top line and bottom line. The bears are pointing out that the Silicon Valley Bank (SVB) and Credit Suisse crises occurred in late March and, hence, the full impact of those events is not apparent in the Q4 results. Clients in the BFSI space were already cautious prior to the run on SVB and are expected to be even more conservative in their budgeting, going forward. Advisories from major financial institutions such as Wells Fargo, Citi, and UBS (which took over Credit Suisse) do indicate they will be cautious since they expect a mild, “short-term recession” in the US. However, many large firms in the BFSI space seem committed to continued spending on specific IT projects, which seem to offer clear visibility of short-term returns in terms of cost savings or the prospects of business expansions.

Revenue splits indicate clients across different industry verticals are also cautious. There are no apparent growth verticals at the moment. On the plus side of the ledger, margins could improve. Hiring has reduced to a trickle and per capita revenues are likely to be sustained. A drop in start-up activity has also led to lower attrition rates and subcontracting rates have fallen. Hence, supply-side costs have eased off. Also, the European Union appears to have seen the worst in terms of economic damage from the Ukraine war, and revenue growth from the region is now expected. Apart from the cyclical downturn, investors are worried that there could be more bad news from the BFSI sector given slow credit growth and high interest rates. If that doesn’t happen, most analysts believe the sector will start recording better growth in FY25, after a growth hiatus of a year or so.

Structurally, more services are likely to move to the cloud, and that ensures a certain base level of contractual activity will continue. While there’s been demand destruction when it comes to discretionary IT spending, projects with fast return on investment are continuing. Over and above all this, there’s the big opportunity and the potential threat of generative AI. More AI deployment is a given, and that could cause tectonic shifts in the way IT services function.  What happens during the transition, and what are the likely timelines for widespread AI deployment? The answers to those questions would play a key role in shaping tech spending in the near future.