BackIT sector outlook: Worst may not be over; Nirmal Bang sees earnings downside risk for FY25-26
Indian IT services sector faces challenges due to low demand, economic slowdown, and US interest rates. Uncertainty post US elections may worsen the situation, leading to downside risks for earnings in FY25 and FY26, according to Nirmal Bang Equities.
PremiumThe worst may not be over for the Indian IT services players. The sector is grappling with low demand amidst an economic slowdown and higher interest rates in the US. This situation could worsen due to uncertainty surrounding economic policies following the presidential elections in the world's largest economy.
Brokerage firm Nirmal Bang Equities sees "further downside risk to earnings for the Indian IT services industry for both FY25 and FY26 as current revenue assumptions seem aggressive in the context of industry commentary, the timing of turnaround in growth, prospects of US interest rate trajectory and uncertainty around US economic policies consequent to the presidential elections."
"We expect 4-7 per cent constant currency (CC) revenue growth guidance by both Infosys and HCL Tech. Even this may be at risk if the Fed funds rate is not cut materially or if enterprise customers freeze up due to US election uncertainty. We see ‘slower for longer’ demand conditions through 2024 that could pare consensus earnings expectations," Nirmal Bang said in a report on March 11.
The brokerage firm pointed out that the enterprise clients of Indian IT Services firms continue restricting their discretionary spending even though the US real GDP grew impressively in 2023. Moreover, announcements around large deals have been weak since September 2023.
"Demand commentary in the first half of the calendar year (1HCY24) from both Indian as well as global IT services firms post December quarter 2023 results has been cautious across the board. Although there have been rare comments around ‘green shoots’ in some areas, most players are talking about a demand pick-up only by 2H2024," Nirmal Banh underscored.
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The Fed factor
Elevated interest rates and the prospects of a shallow rate cut by the US Fed are another matter of concern for the sector.
"The consensus view on the number of rate cuts in 2024 has moved from six to seven (150-175bps) about three months back (when the Fed first proposed them) to three cuts now (in line with the Fed’s view)," Nirmal Bang said.
"Recent hotter-than-expected inflation data has a few economists wondering if the next move of the Fed is going to be a raise. Even if one ignores this minority view, the question is whether a Fed funds rate cut from 5.25-5.5 per cent to 4.5-4.75 per cent (by 75bps) be good enough to entice enterprises to spend more. Up until 2022, enterprises and households have been used to significantly lower interest rates since the Global Financial Crisis (GFC," said the brokerage firm.
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US elections a key factor
Nirmal Bang believes that the US presidential election in November 2024 will add to the uncertainty which could further deteriorate the prospects for the sector.
"Trump has put out his economic and foreign policy agenda which may pose uncertainty not only from first-order effects but also from second-order ones. While the race between Biden and Trump may be close, going by recent media polls, Trump seems to have a lead," Nirmal Bang said.
The brokerage firm believes businesses may be directly impacted by Trump’s tariff plan vis-à-vis not just China but also other countries.
Trump has a different view on immigration compared to Biden. Both these plans, even if implemented in a diluted form, could put upward pressure on inflation, Nirmal Bang said.
There are also likely other measures – like negotiating a quick end to the Ukraine war and a more hydrocarbon-based energy plan that could have a deflationary impact, especially through the energy markets, the brokerage firm added.
Underweight on IT
The brokerage firm has an 'underweight' stance on the firm as it believes a Fed pivot is unlikely in the next six months. Moreover, expensive valuations and high earnings estimates for FY25 leave little scope for healthy returns in IT stocks.
"Even if one were to ignore the next 12–18 months’ risks around recession and take a five-year view, we believe that starting valuations are expensive and can at best deliver mid to high single-digit total stock returns (including capital return to shareholders) for TCS and Infosys, as we believe that structural revenue/earnings growth is being overestimated by the street," said Nirmal Bang.
Nirmal Bang maintains TCS as its industry valuation benchmark and feels that the Indian tier-2 IT set would suffer more.
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Disclaimer: The views and recommendations above are those of individual analysts, experts and broking companies, not of Mint. We advise investors to check with certified experts before making any investment decisions.
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