IT stocks are running ahead of themselves, especially in light of slowing growth and declining margins
TCS’s rival, Infosys Ltd, has done better in recent quarters
Shares of Indian information technology (IT) services companies have outpaced the broader market in the past one year. This is interesting for two reasons. One, their revenue growth rate has been progressively coming down in the past three quarters. Two, they didn’t benefit from the corporate tax cut announced in September, while firms from many other industries did.
To say that IT stocks are running ahead of themselves would be an understatement.
The most stark example is that of Tata Consultancy Services Ltd (TCS). The market leader’s revenue growth stood at 12.7% in constant currency terms in the January-March quarter of 2019. Growth is estimated to fall to below 6.8% in the October-December quarter, according to analysts at Kotak Institutional Equities.
The market’s response to this dramatic change in the company’s fortunes was to send the stock up 22.5% in the past 12 months, which is about three times the rate at which the Nifty 500 index rose during the period. Clearly, the lack of decent investment options is resulting in disproportionately high valuations for quality names such as TCS.
TCS’s rival, Infosys Ltd, has done better in recent quarters. Its growth stood at 11.7% in the January-March quarter, and is expected to drop to a more respectable 9% in Q3. But Infosys shares have risen only about 5% in the past year. The stock has been punished following complaints of wrongdoing by anonymous whistle-blowers.
While announcing its Q3 results, Infosys will do well to clear the air to investors’ satisfaction. Undoubtedly, its shares will make up for the massive underperformance if the company manages to do so.
While this is a company-specific issue, the overarching theme in Q3 results is one of a further growth slowdown.
“We believe moderation in revenue growth is underpinned by sluggish growth in BFS (banking and financial services), retail and manufacturing, high furlough activity and client-specific challenges for a few companies," Kotak’s analysts wrote in a note.
Analysts at Nomura Financial Advisory and Securities (India) Pvt. Ltd said in a note to clients that growth at tier-I IT companies in India is estimated to fall to 8.6% in Q3, from 10.1% in the preceding quarter. Of course, this includes a huge inorganic contribution to revenues of HCL Technologies Ltd. Excluding the impact of acquisitions, growth is expected to be lower at around 7% for the top four Indian IT companies.
What’s more, profit margins continued to be under pressure, although the year-on-year decline in margins will likely be lower in the December quarter vis-à-vis Q2. According to Nomura’s estimates, margins for the top four IT firms were estimated to drop 70 basis points cumulatively in Q3, lower than the 160 basis points drop reported in Q2.
All said, with both revenue growth rates and margins declining, profit growth is likely to be weak for the Indian IT sector this results season.