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Home >Markets >Mark To Market >Deal wins boost tech shares, but margin pressure may limit gains

IT stocks have had a good 2020 with digitization trends accelerating among large global corporations because of the pandemic. This has also set the tone for several large deals in the IT space.

Infosys Ltd and Wipro Ltd announced large deal wins, which have pushed tech stocks even higher. The Nifty IT index is up about 11% in December, compared to the 7% gain in the frontline Nifty 50 index.

However, while the deal wins are good, IT stocks could see some margin pressure. That could also mean that forthcoming gains from IT sector stocks could be limited.

Margin factor
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Margin factor

Some of that is partly because large deal wins need some investments early on in the deal cycle, which tends to cap margins. Large deal margins are also normally lower than average company-wide margins over the life of the deal. Besides, large deal wins also need to be backed with robust delivery.

“Poor execution could lead to customer dissatisfaction, unexpected volatility in margins and profits and, therefore, stock performance," said analysts at Nirmal Bang Securities in a client note.

Even so, the Indian IT sector seems to have managed deal deliveries well in the past. Also, some of the older deals could see better profitability because of the increase in automation levels.

However, the sector still faces headwinds in the form of rising costs as business heads towards normalization.

“Indian techs have benefited significantly from cost savings around travel (2-4% of revenues) facility expenses, and deferred wage, apart from increase in offshore delivery of business in the recent quarters. Some of the costs are sure to come back in the near/medium term as the situation normalizes, in addition to wage increments that the industry is beginning to roll out as growth returns," said analysts at JM Financial Institutional Securities in a client note.

That is driving some analysts to keep their optimism on the margins front in check.

Of course, some of that could still change depending on revenue growth in the coming quarters.

Digitization trends are accelerating post the coronavirus pandemic as corporations move to cloud and hybrid models. Faster adoption of technology at the corporate end could still tend to support margins in the coming quarters.

Even so, the run-up in IT stocks factors in a lot of the upside in earnings. The run-up seems to have made the valuations of IT stocks stretched on the higher side.

The Nifty IT index is trading at a one-year forward price-earnings multiple of 26 times, compared to 18 times at the beginning of 2020.

“While there could be some upside revisions to revenue in FY22 and FY23, we suspect margins have to be lowered a tad, leaving earnings per share broadly constant," said analysts at Nirmal Bang.

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