Results preview: Q3 may drive caution for IT sector, better margins likely

Almost all the tierI companies in the Q2 of FY23 had signalled then that though the current macro has not impacted budget in general, there are specific pockets where delay in deal closure was evident

Traditionally, the second half of a financial year is weak for the information technology (IT) services industry owing to furloughs. But the third quarter of FY23 may be further muted with a deteriorating macro scenario because of which companies are showing concerns on deal closure.

The cautionary note was brought in by HCLTech. The company’s management — during its investor day in the first week of December — indicated that FY23 revenue could be at the lower end of the guidance. The reason for this was higher furloughs in sectors like banking, financial services and insurance (BFSI) and hi-tech.

Almost all tier-I companies had, in Q2 of FY23, said that the macro environment had not impacted budgets in general. However, there were specific pockets where delay in deal closure was evident. These include mortgage, hi-tech, retail and telecom.

According to analysts, it means a top-line growth of 1-3 per cent for top-tier firms. And, for mid-caps, it may vary between negative growth and a positive 5 per cent.

However, this quarter is likely to see improved margins, with supply-side constraints under control and a favourable currency movement.

IT services results will start from January 9, and Tata Consultancy Services (TCS) will be the first company to announce its numbers. Infosys and HCLTech will follow with their numbers on January 12.

Analysts expect Q3 to drive caution for the sector, which so far has managed to show buoyant growth.

“Revenue growth will moderate to high-single digits to low-teens on year-on-year (YoY) comparison. EBIT (earnings before interest and taxes) margin has bottomed out and will likely improve, albeit moderately. We note that the industry escaped the furlough impact in the last two years. This was due to the compressed digital transformation journey as well as large-deal ramp-up,” said a Kotak Institutional Equities report.

The big positive this quarter will be margins. “Easing of supply-side challenges, lower attrition and cost rationalisation will boost margins. Hence, large caps are expected to report 35-117 basis points (bps) improvement,” said an IDBI Capital report.

More than the Q3 numbers, analysts will be focused on management comments about client budgets, total contract value (TCV) growth rate and type of deals on the table. “The return on investment (RoI) focus of clients has increased. Talk of cost take-out deals and vendor consolidation are back.

Vendor consolidation has many flavours, which in some cases will be net-neutral for the industry. It would be gains for a few and losses for others. Companies that have a full-service model, strong execution engine and address the digital transformation agenda are best positioned to gain,” said the Kotak Institutional Equities report.

This has also played out for Accenture. During Q1 of FY23, it hinted that it is seeing some pressure on discretionary spends and will focus on cost-transformation deals.  “We see potential for negative surprises across the board on revenue, led by higher furloughs and pressure on the book. Deal wins could be in line with historical trends in most cases. However, these are deals that have been in the making since Q1 of FY23. Q4 could begin to reflect lower deal flow in our view.

The risk for IT services stocks is continued revenue weakness in H2 of FY23 followed by a tepid start to FY24E,” said Nitin Padmanabhan and Dhvani Shah of Investec in their report.