Worsening client profitability to impact IT demand says Jefferies

• In the fourth quarter of FY23, Indian IT firms experienced a 1% Q-o-Q decline in US dollar revenues, marking the first revenue decline in 11 quarters.
• On an aggregate basis, the consensus revenue estimates for the top clients of IT firms for 2023 and 2024 have remained relatively stable.
• Despite stable revenue estimates, there are ongoing profitability challenges for clients in 2023 and 2024.

The decline in revenue in the IT sector during the fourth quarter was primarily attributed to a decrease in revenues from the top-10 clients. Although the overall revenue outlook of these top clients year-to-date (YTD) remains unchanged, there has been a deterioration in profit outlook, indicating that client profitability plays a significant role in IT spending decisions, as per a report by investment banking firm Jefferies.

Among different industry verticals, the communication, technology, and BFSI (banking, financial services, and insurance) sectors appear to be the most adversely affected. TechM and Wipro have the weakest demand outlook, while Coforge, Wipro, and LTIM are considered to be at higher risk of experiencing negative surprises.

Decline in revenues from top 10 clients concerning

During the fourth quarter of FY23, Indian IT firms experienced a 1% Q-o-Q decline in US dollar revenues — marking the first revenue decline in 11 quarters. This decline was primarily driven by a 3% Q-o-Q decrease in US dollar revenues from their top-10 clients. Revenues from clients outside the top 10 remained flat Q-o-Q.

Among the companies covered in Jefferies analysis, Coforge was the only firm to report revenue growth from its top-10 clients. This decline in revenues from top-10 clients represents the third-largest sequential fall in a decade. Considering that 20-36% of IT firms' revenues come from these clients, it is important to closely examine their outlook.

Aggregate revenue estimates for top clients remain unchanged

On an aggregate basis, the consensus revenue estimates for the top clients of IT firms for the calendar years 2023 and 2024 have remained relatively stable. However, there have been downward revisions of 1-5% in revenue estimates for the top clients of TechM and Wipro, while upward revisions of 2-4% have been observed for the top clients of Infosys and Coforge.

Among different industry verticals, clients in the technology and communications sectors have experienced more significant revenue cuts in their estimates. On the other hand, clients in the energy and utilities, travel, transportation, and hospitality (TTH), and life sciences sectors have witnessed upward revisions in their revenue estimates.

Profitability pressures persist

Despite stable revenue estimates, there are ongoing profitability challenges for clients in 2023 and 2024. The aggregate profit after tax (PAT) margins for the top clients of IT firms have seen downward revisions of 25-40 basis points for 2023 and 2024.

Except for HCL Tech, all firms have experienced cuts in their 2023 PAT margin estimates for their clients, with Infosys, TechM, Wipro, and TCS facing the most significant reductions. The energy and utilities, BFSI, life sciences, and communication sectors have particularly encountered considerable margin pressures.

Profitability key to IT spending

The decline in revenue from top clients in the fourth quarter of 2023, despite unchanged aggregate revenue expectations, highlights the significant role of profitability outlook in determining clients' IT spending in the near future. Among different industry verticals, only the travel & hospitality sector has seen improvements in revenue and profit estimates for 2023.

On the other hand, while revenue estimates for top clients in the life sciences, energy and utilities, and retail sectors have been upgraded, their profit estimates have been reduced, which could have an impact on their IT spending outlook. The technology, communications, and BFSI verticals face challenges as top clients in these sectors have experienced cuts in both revenue and profit.

Outlook weak for Inosys, TechM, Wipro

The steep reductions in revenue and margin estimates for clients of Infosys, TechM, and Wipro indicate potential pressure on the near-term demand outlook for these companies.

With top clients in the communication, tech, and BFSI verticals positioned weakly, Coforge, TechM, Wipro, LTIM, and TCS are more exposed. Taking these factors into account, TechM and Wipro appear to have the weakest growth outlook.

However, when comparing the changes in revenue growth expectations between IT firms and their top clients in FY 2024/CY2023 versus FY2023/CY2022, Coforge, Wipro, and LTIM are at a higher risk of negative surprises in FY24 growth.