After the IT sector's ‘annus horribilis’ in the calendar year 2022, JP Morgan in its note said it expects revenue growth of companies to come down to 6-8 percent from the mid-teens. The reason for this, the analysts said, is due to shrinking tech budgets as well as pricing pressure on the back of higher-than-expected furloughs in the December 2022 quarter.
JP Morgan is below consensus estimates on both growth and margins for most firms and said it expects companies to miss expectations.
Indian IT's share of incremental growth has averaged roughly 22 percent in the last five years, and anything over the 6-8 percent band would be optimistic. Although investors expect Indian IT companies to gain during a slowdown as enterprises will offshore more work, JP Morgan said these will be on managed services deals that have lower pricing, which in turn will impact margins.
Margins under pressure
Margins of IT companies have been under pressure for some time now, which has even resulted in variable pay cuts for employees. The note by JP Morgan said that along with slowing growth, pricing pressure in most vendor consolidation awards is likely to limit the ability to recover margins despite gains from attrition moderating, rightsizing the bench and subcontractor costs as well as pyramid actions.
Since growth is expected to be below 10 percent, it is challenging for companies to recover margins lost in the 2022 calendar year.
“While headline utilization has troughed, this is led mainly by unbilled graduates hired (over-hired) over CY21-22. Utilization metrics (ex-trainees) are understated as several benched staff are recently trained graduates that companies find tougher to place as growth slows down. Stopping/slowing external hiring to drive pyramid corrections also impacts the ability to bring subcontracted staff under control,” the note read.
Due to this, slowing growth in the 2023 calendar year “makes it hard to extract sharp margin management as remaining demand stays for in-demand skills,” it said.
Preview for Q3FY22
Q3 has traditionally been a soft quarter for Indian IT companies, due to fewer working days as well as furloughs. However, JP Morgan analysts said that the slowdown in the Q3FY23 is certain, and furloughs are a fig leaf. Analysts estimated organic quarter-on-quarter growth in constant currency to slow down due to furloughs as well as the destruction of demand.
“In our view, only the Travel/Hospitality, Auto, Healthcare and Energy verticals appear resilient on tech spends,” the note added, as several verticals such as BFSI, Hitech, Telecom, Manufacturing, Retail/CPG are seeing furloughs and delays in decision making.
“While cross currencies have turned sharply since Nov providing a 50-70bps FX cushion to margins, we expect several firms to highlight limited support from here given a lack of operating leverage in 3Q. Parsing the slowdown between true furloughs (lasts one quarter) and demand destruction (no recovery) will be key to tracking FY24 performance. We expect companies may be tempted to view or portray demand destruction as furloughs,” the note further added.
Expectations going forward
JPMorgan expected revenue growth moderation in CY23 or FY24 due to demand destruction, which it said will be evidenced by furloughs, flat budgets in CY23, inflation, rare large deals and pricing pressure.
Another reason the analysts cited is the lack of new disruptive tech drivers beyond cloud adoption, which means growth beyond FY24 could be “modest at best”. Large cloud adoption cycles are expected to hit maturity by CY24-25, the analyst said.
While the muted growth upcoming results season is likely to be blamed on furloughs, JP Morgan said it believes Q4 will be weak as well, due to macro concerns and delays in decision-making driving flatter tech budgets and delayed deal closures.
The days of the mega deal win are over and large deals, too, are slowing down. The note said that a few large deals are expected in CY23 and clients delaying deal closure decisions, due to which it will be tough for scale IT Services firms to clock double-digit growth, and for mid-sized ones to clock mid to high teens growth.
“We expect sustained high inflation to eat into tech budgets as budgets are used up for internal staff compensation and rising licence costs. Enterprises are likely to keep looking at tech vendors as a source of cost deflation, which could also drive pressures on pricing for managed services contracts for application, infrastructure maintenance and business process management work that Indian Techs have turned to in past periods of slowing growth,” the note read.
JP Morgan also said that transformational deals are expected to take a backseat as clients may look to reprioritise spends, which could be another hit for the sector as it has been banking on transformational deals as a growth driver. This normalisation of spends could bring back pre-Covid levels of growth.