JP Morgan warns of another tough quarter for Indian IT companies

Even as the results for the third quarter of FY23 are about to commence, JP Morgan has warned that Q3FY23 and Q4FY23 could be relatively weak for the Indian IT sector. It expects pressure on volumes and on pricing due to the global slowdown expected in the next two quarters. Significantly, the biggest risk that JP Morgan sees to the Indian IT sector in the next two quarters is not on the bottom line but on the top line. The muted growth expectations in the next two quarters can be blamed on furloughs, macro concerns on the economy and delays in decision-making. Also flatter technology budgets and pricing pressures are likely to delay closure of deals.

JP Morgan has also warned that the fall in top line growth can be quite steep for the IT sector. For instance, it expects that revenue growth of major IT companies could come down sharply from the mid-teens to the level of around 7-8%. This fall in top line growth is likely to be triggered by shrinking tech budgets coupled with pricing pressures. Most of the IT companies have also gone on an aggressive manpower cutting spree, which is likely to impact their ability to deliver top line growth. The same has been the case at the client end also, where manpower cuts at an aggressive levels is leading to weaker order flows for technology companies in India. All that is adding up to put pressure on the top line.

JP Morgan believes that on growth and margins, the markets may still be too optimistic or perhaps hesitant to downgrade. It expects that the actual growth and margins may be lower than made out in the current estimates. Ironically, Indian IT companies used to clock top line growth of around 22% on an average in the previous five years. From that level, a fall to the range of 7-8% is going to be a very sharp fall with larger implications for valuations in the case of IT stocks. The positive twist to the whole story is that Indian IT companies could gain during a slowdown as there would be more offshoring of work. However, this would be more on managed services deals; where pricing and margins are much lower.

If top line is one part of the story, JP Morgan feels that margin squeeze would be the second big concern. For instance, margins of IT companies have been under pressure for some time due to rising costs, attrition and travel costs. Going ahead, vendor consolidation is likely to nip the ability of margins to recover to old levels. On the one hand attrition is moderating and rightsizing has reduced manpower costs. However, it also means that the margin contraction should take away part of the gains of such manpower savings. Recovery of lost margins may continue to be a nightmare for the IT companies.

Let us now look at Q3FY23 outlook in greater detail. Even otherwise, the third quarter has normally been soft for Indian IT companies due to reduced working days. That means, QOQ growth would anyways slow. The weak dollar would mean that constant currency growth would be under pressure, not to talk of cross currency pressures as larger IT companies have substantial exposure to multiple currencies. JP Morgan is also worried that there could be genuine destruction of demand due to the slowdown in the global economies. JPM expects that select verticals like Travel, Hospitality, Automobiles and Healthcare could be resilient while the core sectors like BFSI, Hitech, Telecom and Manufacturing could see pressure.

The other view presented by JP Morgan is that large cloud adoption cycles are expected to hit maturity and peak out by CY24-25. That means the new age tech spending could gradually top out. To add to it, macro concerns and flatter tech budgets could also be the reason for weak growth in the future. After all, it is quite evident that large mega deals are slowing down if not ending. The consolidation of vendors, cost deflation and the increased shift to offshoring work would mean pressure on top line and bottom line for Indian IT companies. The situation may not be too grim, and could very well be cyclical, but it does look like the dominance of Indian IT sector as we know it, maybe gradually topping out.

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