Tech investors are driving in a fog

In CY22, the Nifty IT index fared extremely poorly with a correction of 26%. Photo: Bloomberg
In CY22, the Nifty IT index fared extremely poorly with a correction of 26%. Photo: Bloomberg

Summary

The Indian IT industry is returning to revenue seasonality after two years of pandemic-driven digital transformation boost.

The December quarter is usually a seasonally weak one for the information technology (IT) sector, mainly impacted by furloughs and lower number of working days. But this time around, the Indian IT industry is returning to revenue seasonality after two years of pandemic-driven digital transformation boost, as seen in the December quarters of 2020 and 2021. Ramp-up of large deals during this period also helped companies beat the seasonality effect.

But now, with looming risks of a global recession, gauging the demand scenario has become trickier for investors in IT stocks. “A key debate around 3Q growth outlook is how much of the sequential slowdown is seasonal," said analysts at JM Financial Institutional Securities Ltd. The research house estimates that furloughs could have an adverse impact of 0.9-1.4% on revenues. Lower working days could have additional 1.5-2.5% impact, it said.

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Hraphic: Mint
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Hraphic: Mint

This apart, increased cost cautiousness among clients amid macro uncertainties, could hamper the sector’s revenue growth momentum and accentuate pain for IT investors. A worry is that the momentum seen in short-cycle deals could slow down as clients delay their discretionary spends. Remember, IT giant Accenture in its recent results has already indicated about clients’ increased focus on cost optimization. In this backdrop, investors should closely watch the trajectory of large deals and bill-to-book ratios in Q3 earnings.

Further, incremental clarity on demand outlook in Q3 management commentaries is not expected since budgeting at clients’ end may still be underway. This uncertainty does not bode well for the revenue visibility trajectory and overall investor sentiment. Among tier-1 IT services providers, Infosys Ltd and HCL Technologies Ltd are expected to retain their FY23 constant currency revenue growth guidance. That said, meeting the top end of the guided range would be a tall task.

The risk for stocks is continued revenue weakness in H2FY23 followed by a tepid start to FY24, said Investec Capital Services (India) in a report. This could bring down tier-1 growth expectations to 6-7% from 8%. However, tier-2 firms could see sharper revenue downgrades. That said, margins are poised to see a sequential improvement in Q3FY23. This would be aided by improved utilization, freshers becoming billable and favourable cross-currency movement for some companies. Though supply-side pressure is receding, its benefit is likely to reflect in the margins with a lag of one to two quarters.

On an aggregate basis, the sector’s Ebit margins are estimated to recover by 50 basis points sequentially in 3QFY23, driven mainly by HCL, TCS Ltd and Coforge Ltd, said Jefferies India Pvt. Ltd.

Meanwhile, segment-wise, in Q2FY23 commentary, IT companies highlighted weakness in some pockets such as mortgage, retail and hi-tech. It remains to be seen whether more verticals are feeling the jitters of a potential global recession. Geography-wise, the outlook on Europe would be crucial given the energy shortages and inflation the region is facing. Trends in hiring, attrition and wage hikes are also crucial.

In CY22, the Nifty IT index fared extremely poorly with a correction of 26%. Even though the benchmark index Nifty 50 gave modest 4% returns in CY22, the Nifty IT index lagged by a mile. Valuations of IT stocks have cooled off from the recent peaks, but given the aforementioned challenges, they are still expensive.

Tier-1/tier-2 IT price-to-earnings valuations at 22.9x/24.8x are still at around 28/50% premium to pre-covid three-year average, said Ambit Capital Pvt. Ltd in a report on 3 January.

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