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Bounce-back! Charting the path to revival for IT services

* The IT services sector could be on the cusp of recovery after enduring a prolonged period of discretionary spending cuts. As we look ahead to the next 2-4 years, the harsh winter appears to be behind us, and the foundations for a sustained revival in the flow of business and smaller deals are being laid. This report seeks to uncover the key drivers of client spending behavior and identify the necessary shifts to spur a new wave of growth.

* The report is divided into three sections. First, we assess the current state of affairs by examining various verticals to pinpoint the most affected sectors and comprehend the root causes of the downturn. We separate fact from fiction regarding client behavior and the contributing factors. Second, we develop scenarios for the sector’s recovery in both the short and long terms, exploring potential pathways and triggers for renewed growth. Finally, we highlight stocks poised to benefit from the next wave of client spending. We also introduce our IMPACT framework for stock picking, to ride the short-term and long-term technology trends from hereon.

* Our top picks in this framework (details on page 8) are HCL Technologies (TP: INR 2,200; 26% upside), LTIMindtree (TP: INR 7,400; 20% upside), and Persistent Systems (TP: INR 6,300; 22% upside). We estimate HCL to lead revenue growth among large caps over the next three years, driven by its resilient portfolio and engineering services. Our positive outlook on LTIMindtree is based on its best-in-class offerings in data and ERP modernization, with a recovery in US banks' discretionary spending expected to further support its growth. Persistent Systems, with its strong product engineering background, remains the fastest-growing IT services company in our coverage and is well-positioned to benefit from long-term GenAI investments.

* Additionally, we are upgrading Coforge to a BUY (TP: INR 8,100; 25% upside) in this report. We believe Coforge can leverage synergies from Cigniti, while healthy growth in its executable order book bodes well for its core business.

Starting from the bottom, where do we go?

At first glance, the dip in growth rates over the past two years seems to be due to: 1) a pause in client transformation spending after a pandemic-induced spending frenzy on cloud adoption and scalable infrastructure; 2) a generational shift in interest rates and inflation dynamics, which has caught clients unaware; and 3) simple mean reversion. However, a closer look reveals a more nuanced scenario, indicating potential pathways to recovery. The US BFSI sector has been one of the hardest hit, despite banks maintaining their technology spending. Capital-intensive sectors like telecom face structural issues in service spending due to high interest rates and the aftermath of a historic capex cycle. However, we believe that in most sectors, the path to recovery lies not in reversing technology spending cuts but in adapting to a structural change in client behavior that will shape the growth dynamics of the next upcycle.