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A raging debate on the rising likelihood of a recession in the US has made investors in Indian information technology (IT) stocks nervous. Worries of delayed client spends hurting the sector’s revenue growth and deal pipeline have already led to cuts in earnings estimates for FY23. In this context, management commentary on the demand environment in the upcoming June quarter (Q1FY23) earnings season is crucial.

At the same time, investors need to focus on margins. Expectations are that Ebit (earnings before interest and taxes) margins for most IT companies would contract in Q1FY23. The high cost of talent acquisition due to the ongoing supply crunch, retention bonuses and wage hikes are among factors that would weigh on the sector’s margin movement.

A sour point
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A sour point

“Investor focus has shifted to a potential demand slowdown, while IT firms are dealing with a separate challenge i.e. talent shortage to meet demand," analysts at Kotak Institutional Equities said in a report. The domestic brokerage cautions that the June and September quarters would represent the peak of margin pressure and forecasts 70-400 basis points year-on-year decline in Ebit margin in Q1FY23 for IT stocks under its coverage.

True, a depreciating Indian rupee is a positive for Indian IT firms as they are exporters of these services. However, this time around, the actual impact on containing margin compression may be limited. “Margins would see a sequential contraction for most IT companies. This would be partly due to visa costs, wage hikes and return of travel expenses. Rupee depreciation could provide some comfort to margins, but headwinds are far stronger," said Kumar Rakesh, a senior automobile and technology analyst at BNP Paribas Securities India.

What’s more, any negative surprise on margins may result in more earnings downgrades for the sector. Rakesh is of the view that the risk of further earnings downgrades for the sector remains, depending on how disappointing upcoming results and global macro data are. “Consensus earnings downgrades for FY23 this year have been in the 1-7% range which, we feel, does not capture the recession risks yet," he added.

Note that recent commentary by global IT giant Accenture points to the demand conditions remaining robust. Amid strong demand, attrition rates would also remain elevated for the industry, at least in the near term. To tackle this, Indian IT companies have been on a hiring spree, especially freshers. In general, the net hiring pace for IT companies has increased in the last three years.

Analysts note that hiring more freshers improves the employee pyramid for IT companies and bodes well for margins, but benefits will show over a period of time. Another tailwind for margins could come from price hikes. A report by ICICI Direct Research points out that price hikes have been a part of active discussions of firms with their clients and some of them are getting price hikes in a few pockets. However, any meaningful price hike is yet to come, added the report.

Meanwhile, the Nifty IT index has declined by 28% so far in this calendar year. The fear of a slowdown in FY24 earnings, if not a full-fledged recession, is likely to keep IT stocks under pressure in the short term, said analysts. Expectedly, the steep correction in IT stocks has led to a decline in their valuations. Bloomberg data shows that the shares of Tata Consultancy Services Ltd, Infosys Ltd and Wipro Ltd are trading at FY24 price-to-earnings (PE) multiples of 25x, 21x and 15x, respectively. While the valuations of IT companies look reasonable now, in the event of steeper earnings downgrades, price-to-earnings multiples could further moderate.

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