IT index outperforms Nifty in 2024 but is all really well with the sector? Here’s what investors should know
In a recent note, brokerage house Ambit Capital noted that the March quarter (Q4) outlook doesn’t suggest immediate recovery for IT. It prefers Tier-1 IT over Tier-2 IT.
The information technology (IT) sector has outperformed Nifty in 2024 year-to-date (YTD), surpassing the benchmark again after 2023. In 2024 so far, the Nifty IT index has jumped around 6 percent as against a 1.65 percent gain in the benchmark.
The IT index has risen over 3 percent in February so far, extending gains for the fourth straight month. Before this, it added 3.16 percent in January 2024, 9 percent in December 2023, and 6.5 percent in November 2023. The index hit its 52-week high of 38,559.85 earlier this month on February 19, 2024, following the overall positive sentiment in the Indian market.
In a recent note, brokerage house Ambit Capital noted that the March quarter (Q4) outlook doesn’t suggest immediate recovery. It prefers Tier-1 IT over Tier-2 IT. The brokerage suggests that the current environment, with growth and margins likely to remain below pre-Covid levels, may not support the structural increase in valuations based on growth alone.
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"Q3 growth beats were led by single segments at most and not broad-based, with large segments (US, Europe, BFSI, CMT, Retail) still sluggish. Last 12 months' deal flow growth of 5-18 percent at HCL Tech, Wipro, TCS, Mphasis, Coforge, and Persistent Systems and an over 40 percent decline at Tech Mahindra doesn’t support sharp recovery hopes as deal durations are rising," said Ambit.
The brokerage retains a view of modest growth improvement in FY25E and a fall in Tier-1 margins (contrary to street hopes of increases). It believes that Tier-1/Tier-2 one-year forward P/E premium of 55 percent/116 percent to pre-Covid 3-year average looks unsustainable.
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Up-fronting of margin levers could come back to bite
The brokerage pointed out that EBIT margin beats were seen at 5 of 9 companies, but ex-Persistent Systems/LTIMindtree, EBIT margin was still 1-7 percent lower than pre-Covid (Q3FY20) across coverage. Margin beats were driven by the up-fronting of levers (sub-con/staff cuts), which could come back to bite when growth returns. Ambit sees operating leverage getting played out by Q4 itself and headwinds from incremental hiring, wage hikes, and deal dilution in FY25.
Ambit expects the top 4 EBIT margins to decline 50bps to 20.3 percent over FY23-26 (vs 22.2 percent in FY22). The cost of growth needs to be watched on cash flows, wherein FCF (free cash flow) CAGR was lagging EBITDA CAGR over the last 2 years for 5 of 9 coverage companies.
Valuations building structural uplift in demand unsustainable
As per the brokerage, the narratives on discretionary pick-up seem to have been lapped up even as companies indicated a limited change to client spending behavior. It believes in a scenario of growth/margins likely below pre-Covid, valuations building a structural uplift in growth are unsustainable.
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Ambit prefers turnaround plays Tech Mahindra and Cognizant or better segmental skew - HCL Tech. It likes Infosys over TCS on cheaper valuations and risk of growth versus margin trade-off at the latter. In Tier-2, which are all SELLs, Ambit prefers Mphasis on cheaper valuations, growth gap reduction in FY25 and the possibility of benefits from rate cuts in the mortgage business.
The IT sector, traditionally considered defensive, is now exhibiting a different trend, with valuations currently sitting at a 35 percent premium to the Nifty index, significantly higher than the historical premium of 9 percent. Moreover, the implied growth in the sector is noticeably higher than pre-Covid levels, indicating a shift in market dynamics.
Ambit's pecking order: TECHM (BUY)> Cognizant > HCLT > Infosys > TCS > Wipro > Mphasis > Coforge > Persistent > LTIMindtree (SELLs).
Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.
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