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Optimism abounds; not enough substance yet

IT stocks have rallied 7-18% in the past one month, especially during last week. While the Fed’s move warranted an upward movement in stock prices, the resulting rally was a tad optimistic, in our view. Our current revenue growth and EPS estimates already factor in the positives for FY2025—(1) soft landing in the US and (2) abating of demand headwinds. We increase fair values by 9-20% on rollover and increase in multiples factoring in lower macro uncertainty. The strong rally limits further upside in select stocks. We downgrade HCLT to ADD from BUY and Persistent to REDUCE from ADD.

Downgrade HCLT and Persistent post sharp rally; increase fair values

Rollover to December quarter and ~2X increase in multiple factoring in lower macro uncertainty following rate cut path laid out by US Fed lead to 9-16% increase in FVs for IT stocks (see Exhibit 1). We cut rating on HCLT to an ADD from BUY following 13% stock price increase in the past month. We also cut rating on Persistent to REDUCE from ADD. The stock trades at 33X FY2026E EPS and is expensive after 22% rally in the past three months.

Current estimates already factor in soft landing and abating of headwinds

IT services firms faced a tough demand environment in FY2024 due to (1) reluctance to commit to new programs given high economic uncertainty, (2) reprioritization of spending away from Covid-era priorities toward efficiencies and optimization, (3) excess in-house hiring and (4) longer sales and ramp-up cycle in mega deals. These headwinds resulted in muted revenue growth of 2-5% for large companies and 6-14% for mid-tier names. Revenue declined for Wipro, TechM and Mphasis. These headwinds have bottomed out and will incrementally aid demand and revenue growth in FY2025. Our base case already factors these tailwinds and a soft landing for the US economy.

Multiples lower than FY2022 peak but also with lower forward growth estimates

Current one-year forward PE multiples are lower but approaching peak one year forward mu­­ltiple during FY2022 (see Exhibit 2). However, forward growth estimates are also considerably lower. Our current FY2026E revenue growth estimates for IT companies are 1-4% lower than our FY2024E growth estimates two years ago (see Exhibit 3).

Majority of stock price increase YTD has been a function of re-rating

Exhibit 4 provides YTD stock price increase for IT companies. Note that multiple re-rating accounts for majority of the increase even though FY2024E and FY2025E growth estimates have declined in the same period, especially for stocks such as Mphasis and TechM. Hope of improvement has not reduced even after multiple quarters of disappointment.

Infosys is our top pick followed by HCLT

Infosys remains our top pick among IT services companies under coverage. We expect growth to normalize to 9.1% in FY2025E from 2% in FY2024E. Upside has reduced for HCLT following the recent sharp rally; it remains our next pick. Cyient is the preferred pick in mid-tier. There are interesting names among mid-tier, namely Persistent, but they trade at expensive valuations.

Strong pick-up in discretionary spending in 1HCY24 appears less likely given cost focus

Enterprises across most sectors are focused on cost-reduction priorities. Many have outlined cost-savings targets that stretch into 2024. The reprioritization of spends toward focus areas of investment is not yet complete. Commentaries of select banks and financial services firms do not indicate a healthy increase in technology budgets yet. These do not inspire confidence of a significant recovery in discretionary spending at least in 1HCY24. Trends around cost-reduction mandates and tech-spending outlook across individual sectors are detailed in our recent note.

Core long-term investment themes remain intact

The intent to invest in tech continues across all sectors with a focus on digitalization, automation, back-end systems and AI initiatives. We expect core modernization leveraging a host of digital technologies to be a priority area of investment for the next several years. Catch-up in investment spending is possible once the macro improves.

Two good years and two bad years have yielded normalized CAGR

FY2021-24E revenue CAGR of IT services companies is in approximately similar range as FY2019-20 revenue CAGR, especially for the top 4 (see Exhibit 5). Persistent is a notable exception. Strong growths in FY2022 and FY2023 have been offset by moderate-to-weak growths in FY2020 and FY2024E. Interestingly, organic revenue CAGR in FY2021-24E is significantly lower than FY2019-20 CAGR for Mphasis.

We expect 9-11% revenue growth for top 3 in FY2025E; upgrade to estimates less likely

Our estimates bake in a strong June quarter and continued strength in September quarter as well (see Exhibit 6). This assumes a soft landing, continued momentum in large and mega deal signings and significant recovery in discretionary spending, especially in highly impacted verticals of financial services and hi-tech. We note downside risks to June quarter estimates given that enterprise focus on cost reductions will likely continue in 1HCY24. Growth beat in 2HFY25 is possible in case of strong pick-up in discretionary spending but will not lead to significant improvement in FY2025E estimates for IT companies, in our view.

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