Turnaround awaited

Demand environment remains challenging for IT

The third-quarter results of the big four information technology (IT) companies, read along with their respective management commentaries, indicate that the industry believes the worst of demand slowdown to be over. However, these companies remain notably cautious in their expectations of short-term demand revival. Tata Consultancy Services (TCS), HCL Tech, Infosys and Wipro all met or exceeded the consensus revenue expectations. They also more or less met profit and margin expectations. Given the surprisingly strong performance of the US economy, which is the key market for Indian IT, investors were also expecting strongly optimistic guidance. However, while management commentaries are positive in stating the worst of demand and margin compression is over, no company seems to believe there will be an immediate surge in demand. Indeed, at least two companies said the trend of clients deferring discretionary spending was still there.
 

On the plus side of the ledger, they all see steady traction in new lines such as artificial intelligence (AI), and Cloud-based products in HCL Tech’s case. They also appear to be confident about the respective pipelines in terms of new deal wins. TCS, which has the biggest European exposure, says EU spending may be normalising after two bad years. Three of the large companies saw reductions in headcount continuing but the pace of workforce contraction slowed. HCL Tech was the only firm to increase its net headcount. It also had the best results by both revenue growth and margin improvement. However, the company’s management said the demand environment had not seen much visible improvement.
 

Attrition has dropped perceptibly across the industry, going by the churn rates, which are now in the 12-15 per cent range. But this is also symptomatic of a slow-demand scenario since attrition invariably increases when the industry is seeing high demand. Management commentary from TCS and explicit revenue guidance from the other three companies indicate all four have maintained future revenue expectations. But none of them has claimed any visibility of stronger revenues in the near term. All are witnessing great interest in AI among clients, but that is not necessarily translating into big orders yet. Some clients are also looking at another round of Cloud migrations. In the somewhat longer term, sustained growth in the US, along with low inflation, could lead to demand acceleration. Clients that have deferred discretionary spending may start negotiating deals again.

However, certain changes in the past two or three years could have a long-term structural impact on the IT services market. More and more large organisations have invested resources in developing internal competencies, leading to a proliferation of global capability centres (GCCs). By definition, this will mean less outsourcing demand. Many organisations have also completed their migration to the Cloud, which may impact demand in this segment and reduce the need for future outsourcing. AI has not yet started to make large contributions to revenues and profits, though this is a growth area. The big firms may all be displaying abundant caution in their management commentary and guidance. And they could deliver positive surprises if the long-awaited upcycle arrives. However, they need to review business models in light of the structural changes implied by AI adoption and a move to GCCs.