Why should a Morgan Stanley upgrade lift all IT stocks?
A rising tide may lift all boats, but to expect higher IT spending to benefit all Indian IT companies is clearly taking things too far. Morgan Stanley said in a 15 January note that “an improving global macro could spur tech spending, which could re-rate stocks”. The four biggest IT stocks listed on the National Stock Exchange rose between 4.1% and 5.9%, although part of that could be due to the weakness in the rupee, after the trade deficit for December came in at a three-year high.
Ironically, the biggest gainer was the Wipro Ltd stock, on which Morgan Stanley still has an underweight rating with a target price of Rs290. Wipro shares rose to Rs334 apiece on Tuesday. Investors are taking the rising tide argument far too literally.
For that matter, even Morgan Stanley’s thesis is predicated upon the assumption that a turnaround in global IT spending will result in better times for the Indian IT sector.
This isn’t necessarily the case. In recent years, multinational firms such as Accenture Plc and some small companies such as EPAM Systems Inc. and Globant SA have done far better than Indian IT firms, with spending patterns shifting towards new technologies at the expense of traditional services.
Data collated by ISG, the world’s largest third-party outsourcing deal adviser, shows that Indian IT companies have lagged by a huge margin in the Americas region, despite high growth in overall deal flow. Growth in total deal flow tracked by ISG rose as much as 37% in Americas in the second half of 2017.
“While the deal flow momentum in Americas was positive, the perplexing factor remains that for the top-4 Indian IT companies, growth in Americas has decelerated to 5% y-o-y in 2QFY18 (versus its near-term peak of 14% y-o-y)”, analysts at Nomura Research wrote in a note to clients. Results of Tata Consultancy Services Ltd and Infosys Ltd for the December quarter show that the weakness in growth continues—the former reported growth of less than 3% year-on-year in the Americas region. In short, the tide was rising in America, but it didn’t really lift Indian IT companies with it.
A 2018 outlook report by ISG suggests this trend might continue in 2018. “Traditional sourcing will continue to face pricing pressure (as clients look to do more with less)... Traditional sourcing momentum remains slow... deal flow grew 3% y-y in 2017 (and is estimated to grow 4% in 2018),” Nomura’s analysts said in the note citing the ISG report. What ISG classifies as traditional sourcing is the bread and butter segment for Indian IT companies.
The other category of deals ISG tracks is classified as “as-a-service sourcing”, which includes Software as a Service and Infrastructure as a Service. This can be used as a rough proxy for digital spending, a segment where Indian IT companies have been lagging. Even here, ISG has indicated that deal flow is expected to fall to 20% in 2018, compared to 36% in the previous year.
So while there is some excitement that digital deals are getting larger, this needs to be tempered by the fact that the total value of these deals is expected to grow at a slower pace. After all, if Indian companies are going to end up with mid single-digit growth rates in fiscal year 2018, at a time when digital spend grew at a scorching pace, why should they do even better when growth rates in the digital space are slowing and deal flow in the traditional sourcing space is more or less flat?
In sum, betting on a turnaround for Indian IT may well be premature—much the same as it was a year ago, when a number of analysts said a pickup in spend by BFSI (banking, financial services and insurance) clients will result in a recovery in growth rates. Of course, that trade didn’t end very well. As the other famous quote about tides goes, “When the tide goes out, you discover who’s been swimming naked.”