IT Sector Update : Cloud (of the wrong variety) on the horizon? By JM Financial Services
Cloud (of the wrong variety) on the horizon?
IT Services’ 3QFY25 results were, in general, marginally better than expectations. Barring HCL, others met or exceeded top-line estimates. Earnings beat were however limited to a few (WPRO/PSYS) and followed better margin performance. Unsurprisingly, meaningful EPS upgrades were restricted to these names, and Coforge. Management tone was cautiously optimistic. Their outlook was informed by higher ACV growth (TCS/HCL/WPRO) and sustained discretionary spend in BFS. 3Q results however appear a distant memory now. Uncertainty has crept in the economic outlook since. Trade war seems imminent. Recalcitrant inflation has pushed out fed rate cut hopes and plunged consumer confidence in the US. Such uncertainty is anathema to IT Services demand. To make matters worse, it has coincided with clients’ budgeting cycle. Two of the three guidance into CY25 – Accenture (ACN US; NR) and Capgemini (CAP FR; NR) - imply no organic growth acceleration in FY26. The third one, that is Cognizant (CTSH US; NR), suggests otherwise. But that is more a reflection of CTSH’s own turnaround than broader demand environment, in our view. In our recent interactions with IT Services players, we picked up sporadic instances of pause in transformation programs by large US banks. This, if spreads, could put Street’s (and ours) FY26 growth estimates at risk. Our estimates and TP are unchanged for now as we seek more evidence. But will advise flight to safety, that is, stocks with earning resilience and valuation buffer. TCS/INFO tick those boxes.
* 3QFY25 in a nut-shell: Large-cap companies (top-6) grew 0%-3.8% cc QoQ in 3Q. Barring HCL, others met or exceeded expectations. Mid-cap outpaced larger peers again with 0.2%-8.4% cc QoQ growth, led by Coforge. Auto ER&D slowed down, albeit less than anticipated. WPRO/TECHM among large caps and PSYS among mid-caps did better on margins. Deal wins performance was mixed. TCS, LTIM and TECHM (on a low base) did well while other large-cap peers reported flat to negative growth.
* Outlook, then and now: Most players had echoed cautious optimism in their 3Q commentary. They cited improvement in short duration deals and continued discretionary spend in BFS. TCS indicated reduction in deal decision cycles (for USD 20mn+ TCV deals). HCL reported 23%+ YoY growth in ACV. WPRO highlighted improved traction in USD 1- 10mn deals. Part of the optimism was predicated on reducing uncertainty as new US administration took office. Anything but that has happened since. Tariffs and counter tariffs have infused more uncertainty. Inflation and rate cut trajectories have worsened. Our recent interactions with IT Services players gave us mixed signals. Few are maintaining their 3Q view still, especially on BFS. We also picked up instances of pause in large programs by US banks. That, if expands, does not bode well.
* Global commentary and guidance: CAP guided for -3% to 0% organic growth guidance for CY25, below their CY24 organic growth of -2.4%. They even indicated that 1HCY25 will likely be similar to Q4 (-1% YoY). Higher exposure to EU manufacturing explains their muted outlook though, and may not be have a direct read-through for India IT Services. CTSH, on the other hand, guided for 1%-4% cc organic growth in CY25, better than their CY24 performance (0%). CTSH’s better guidance stems from their strong deal wins in CY24. They won 29 USD 100mn+ deals vs 17 in CY23, something we have not seen for India IT Services players . In fact, they indicated low-to-single digit growth in ACV in CY24, in-line with their guidance. We estimate that INFO’s ACV growth could be in similar range too, though limited data on sub-USD 50mn deals make this prone to error.
* Sector view - caution over optimism: Consensus (VisibleAlpha) estimates (as well as ours) are building growth acceleration in FY26 across large-caps. Assuming normal seasonality, it implies 1.9%-3.3% CQGR in 1H (Exhibit 3). Pause in discretionary, especially in BFS, could put these estimates at risk. Recent correction in the sector (NSE-IT down 8% MTD) seems to reflect that. Though we have left our estimates unchanged for now, we will stick to stocks that offer earning resilience and valuation buffer. TCS trades at 9% discount to its 5-year mean. INFO is trading at par. Investors should stay with these.
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