IT sector could face volatile times

If you are also concerned about the performance of the IT index and are thinking of investing in this sector, you would want to know about the outlook of this sector. In fact, in an environment of high interest rates, the domestic IT sector has been grappling with weak demand from clients in major markets like the US and Europe for more than a year. The results of major IT companies in the March quarter were mixed. During the quarter, many companies received strong orders and also saw margin improvement due to higher efficiency and better utilisation. However, the managements of these companies have indicated that the ongoing weakness in demand is likely to persist, posing blurred outlook for this sector.

Fourt quarter results

First, let’s understand how the fourth quarter results of IT companies were.  In the fourth quarter of FY24, most IT companies, including HCL Tech, Wipro, Infosys, and L&T Technology Services, reported mixed results. Infosys, Wipro, Tech Mahindra, and LTIMindtree saw a quarter-on-quarter decline in revenue growth. Meanwhile, HCL Tech, Oracle Financial Services (OFSS), and LTIMindtree witnessed pressure on their profits compared to the December quarter.

Margins under pressure

During the quarter, margins were aided by a reduction in subcontracting costs and better utilisation, but wage hikes and higher travel expenses ate into a significant portion of this benefit. The situation is such that except for TCS, the margins of IT companies in FY24 have reached their lowest levels in three years. The Russia-Ukraine war that began in February 2022 caused difficulties in Western countries and its impact is reflected in the margins over the past few years.

Atrition rate

As far as the number of employees is concerned, the three largest IT companies saw a decline in their employee count in FY24, which happened for the first time in the last 20 years. The employee count in Infosys has decreased by 25,994. This is the first time the company has seen a decline in its employee count since 2001. However, the benefit of the decrease in employee count was seen in the attrition rate, or the rate at which employees leave their jobs, for these companies. In the fourth quarter, the attrition rate for most IT companies either remained stable quarter-on-quarter or decreased.

AI impact

Now let’s understand what the outlook for the IT sector is.  Experts believe that high interest rates, a soft recession, and weak consumer sentiment in developed countries are major challenges for the IT sector. Additionally, the increasing use of generative AI is causing a major shift in the industry. With the growing use of machine learning, AI, and other technologies of the new era, there is a risk of many IT jobs such as testing, routine coding, and maintenance becoming automated. The revenue growth guidance from select major IT companies in the fourth quarter was disappointing. However, the deal wins or new orders for IT companies have remained strong, but it will be important to see whether these companies can convert these deals into revenue or not.

Weak guidance

This is because the guidance issued by companies is not encouraging, which indicates that there will be a slowdown in IT spending by clients, and there is little expectation of an increase in expenses. For FY25, Infosys has given revenue growth guidance of 1-3%, which is significantly lower than brokers’ estimates. Similarly, HCL Tech has also provided revenue growth guidance of 3-5%, which is much lower than the estimate of 5-7%. However, the good news is that in FY22 and FY23, HCL Tech delivered margins as per its guidance of 18-19% and expects to maintain the same range in FY25 as well. Despite the poor revenue growth guidance, Infosys has also maintained a margin guidance of 20-22%.

Brokers’ view

Now it is also important to know what brokers and experts are saying about the companies in this sector. In view of the ongoing challenges, experts do not seem optimistic about domestic IT stocks. According to them, inflation has stabilized, interest rate cuts are expected to begin soon, and US GDP growth in the first quarter was the slowest in two years, clearly indicating signs of a slowdown in the economy. Based on all this, it is difficult to say that the bad phase for the IT sector is over. After the results, JPMorgan has upgraded most of the small and mid-cap stocks and also increased their targets.

Many experts are advising caution regarding IT stocks and suggesting to selectively pick quality, large-cap stocks from the sector. The results of the next quarter, i.e., the first quarter of FY25, will be crucial for IT companies. According to an analyst, if the companies’ order books remain strong and the global situation stabilizes, then selected stocks can be gradually accumulated over the next two quarters.

So, a neutral view should be taken on the IT sector in the short term and an optimistic view in the long term, as there could be volatility in the market over the next 1-2 quarters. If investors have a long-term perspective, they should focus on companies with strong balance sheets, robust order books in AI and generative AI technologies, and those diversifying across different sectors. Stocks of such companies can be gradually accumulated.

(Disclaimer: Stocks recommendations by experts or brokerages are their own and not those of the website or its management. Money9.com advises readers to check with certified experts before taking any investment decisions.)