Cloudy forecast steals the margin shine from IT stocks

While the jury is still out on whether a recession is a given, better-than-expected margin performance in the September quarter (Q2FY23) is a breather for nervous IT investors. Lower employee and subcontracting expenses were among the factors that aided sequential earnings before interest and taxes (Ebit) margin improvement for most IT companies.

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On an aggregate basis, Ebit margins for tier-I IT companies rose 90 basis points (bps) sequentially, showed an analysis by Ambit Capital. One basis point is 0.01%. Excluding Wipro, Q2FY23 margins across tier-I IT companies exceeded consensus estimates by 20-100bps, said the Ambit report on 15 November. On a year-on-year (y-o-y) basis, margins of these companies fell. Tier-II firms showed better resilience with aggregate margins rising by 30bps sequentially and 10bps y-o-y. “This should provide some comfort and pave the way for a pause in the sector’s earnings downgrades, if not an immediate reversal," said Kumar Rakesh, a senior technology analyst at BNP Paribas Securities India. The depreciation of the rupee in the quarter has helped margins and margin outlook to a certain extent, he said. Kumar sees a weaker rupee boosting margins in Q3FY23 as well, typically considered a weak quarter for the sector due to furloughs.

In recent quarters, operating margins of IT firms came under pressure as they were on a hiring spree. Discretionary and travel costs also made a comeback after the pandemic. This, along with global macro uncertainty and the anticipated impact on revenues and supply-side challenges, triggered steep earnings downgrades for IT stocks.

Analysts at JM Financial Institutional Securities Ltd note that the Street is now baking in mid-high single-digit revenue growth for FY24 across tier-I companies. So, they reckon that the earnings per share downgrade cycle, as seen in the past nine months, could be headed for a pause due to better margin outlook and likely moderation in the Street’s FY24 revenue growth expectations.

In Q2, revenue growth for most IT companies was largely in line with expectations. Also, the management commentary on near-term demand outlook is cautiously optimistic. Most company managements stated that their deal pipelines were robust. But investors should not get too complacent.

Despite margin levers such as higher utilization and freshers turning billable, the recovery in margin would be gradual. “While FY23E street margin expectations have reset closer to our estimates, for FY24E we believe consensus is still aggressive," said the Ambit report. Note that large-cap IT companies such as Infosys Ltd and HCL Technologies Ltd revised their FY23 Ebit margin guidance to 21-22% from 21-23% and 18-19% from 18-20% earlier, respectively.

That said, analysts at Nuvama Research are of the view that a bigger risk for IT companies arises from slowing demand rather than margins. “This is attributable to deteriorating corporate profitability outlook in the US," according to Nuvama. This means trends in client spending become crucial for IT investors.

Souring investors’ sentiment towards the IT sector has led to valuations cooling from their recent peaks. Even so, the lack of visibility on the sector’s FY24 revenue growth outlook remains. Therefore, despite the moderation, valuations of IT companies still look uncomfortable.

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