Discretionary spending starts to slow down, predictably
Ever since the prospect of a technical recession broke in the US, it was mere prudence to get a bit cautious about the growth visibility for IT Services businesses. Every time the US Fed has embarked on an aggressive rate tightening regime, it has always broken something in the economy. This time around, it was predictably some US banks that went under. Not because of faulty lending practices but because of asset liability mismatches. The glut of customer deposits that flew into banks post COVID had to be deployed somewhere, with no opportunities to do prudent lending banks went into bonds and MBS that were rated AAA and considered “very safe”. Just that they underestimated duration risk in fixed income portfolios and couldn’t exit their inventory of bonds without taking large MTM hits. All it took was for a % of customers to call back their deposits and the whole pack collapsed. Fractional reserve banking is always vulnerable to sudden bank runs.
Financial services is one of the largest consumers of IT services in the US. This in combination with the slowdown in tech implies that 35%+ of the portfolio of IT Services majors is going to be under duress through FY24. When the FANG businesses started laying off employees, it was pretty clear that discretionary IT spending would come down. Once Mckinsey announced layoffs, it became all the more clear that consulting spending would suffer in the immediate term. No large corporation wants to spend millions of dollars on how to optimize when laying off 10% of the workforce is the obvious solution.
The disappointing part of this entire saga is the tendency of Indian IT Services managements to communicate like diplomats when they should have been sounding a note of caution at the beginning of the FY itself. When the management of a 2,000 Cr chemicals business can flag off the unsustainability of 20%+ EBITDA margin post FY22, I sometimes wonder what stops the IT management from being a bit more frank. But then I remember that when people have built their entire careers on communicating softly and not calling out ground reality for what it is, it is not reasonable to expect any candid comments from them. The good thing here is that we could see this coming and steered clear of having any direct IT exposure through FY23. Exiting L&T Infotech and buying the parent instead has been a very profitable pair trade for us. The entire core business of L&T was trading at 0.7x the market cap of L&T Infotech when we made this pair trade.This drills home an important point in investing – when you know an industry well enough, you should back your judgement and disregard the opinions of sell side research analysts for the most part.
Coming to our summary of Q4 investor calls –
- Deal wins were strong for all players even through Q4, probably because the process for these deals started much earlier in the CY22 budgeting process. Budgeting exercise for CY23 is most probably going to be much slower and the pace of deal wins might start moderating around Q2 FY24
- Order book to billing ratio has started suffering, customers are revisiting their orders and deferring those that do not have a business need right away. Order books need not translate into billing all the time, I have personally seen deal wins getting cancelled in 2011 once the sovereign debt crisis started in the Eurozone. Sometimes clients refuse to pay invoices even after projects have started
- None of the large players have done any hiring of note in H2 FY23. Net employee count is either flat or lower since Q2, many freshers have seen their joining dates get deferred. A few organizations have on boarded freshers at salaries lower than what was committed. Attrition predictably has come off the highs and might fall into single digits soon. Balance of power has conclusively shifted back to employers after a brief reversal in FY22 and FY23
- Valuation of IT businesses has moderated and come back into the 10 year range, though it is still a tad higher than the historical range. Till FY21 investors believed that only TCS deserved a 20+ TTM PE, all others would trade at lower multiples. Infosys is close to breaking the 20 PE mark post their Q4 commentary
- CTS has announced that it expects to see lower revenue for FY24 YoY and is doing another round of layoffs, a few other IT companies might do this with a lag
- Pricing hasn’t seen any volatility yet but if the pace of deal wins starts to slow down, this might become a factor too. I experienced this first hand in IT sales during 2009-11
Managements will talk of challenges only after they materialize, this is what experienced IT investors are worried about right now. Infosys share price falling ~33% from the peak is not a joke. The objective is not to be a pessimist but to consider all possibilities and have an understanding of how a muted demand cycle affects revenue first, followed by the pace of deal flows and finally pricing.
IT Services may present a decent accumulation point in FY24. Valuations are reasonable though they aren’t as cheap as we would ideally want them to be. At the right price buying an IT services business with a 3-5 year horizon can net an easy, stress free 20% p.a. These are behemoths that offer good corporate governance, asset light balance sheets and excellent unit economics. What has worked well over the past decade is to buy pessimism and sell optimism in this sector, we will try to do this if the opportunity presents itself in this cycle.
Tracking the developments keenly from here on. Patience is paramount to investing success when buying well discovered large cap businesses.
