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Investor optimism in the IT sector is flying on a wing and a prayer

Finally, investors in IT services sectors have something to rejoice about.

Last Thursday, Tata Consultancy Services Ltd and Infosys reported their third-quarter earnings. TCS, which does not give any quarterly or annual guidance, fared better as the revenue and profit came better than what analysts expected. Infosys’s performance fell short of analysts’ expectations.

But investors gave a thumbs-up: Shares of TCS and Infosys surged 4% and 8%, respectively, on Friday. HCL Technologies and Wipro declared their October-December earnings on Friday, post-market hours.

The earnings were, again, nothing to celebrate. Still, shares of HCL and Wipro surged over 4% and 13% on Monday.

     

So what gives?

Firstly, the rally in IT shares started in November last year when the US Federal Reserve kept interest rates unchanged amid a more accommodative commentary that hinted that borrowing costs were high enough to weigh on economic growth. Investors concluded that the US Fed Reserve could do away with raising interest rates, which would allow companies, across industries, to spend more on business, including beefing up their technology infrastructure.

Between 1 November and 15 January, shares of TCS and Infosys are up 16% and 20.7%, respectively. HCL shares are up 24.5% during this time, while Wipro has been the best-performing scrip, as its shares are up 29.5%.

Shares of all four companies outperformed the BSE Sensex, which has returned 15% during this time.

Secondly, all IT services firms are focused on improving their profitability. TCS’s operating margin totaled 25% at the end of December 2023 compared to 24.5% at the end of December 2022. Infosys’s operating margin declined 100 basis points from 21.5% to 20.5%. But profitability was hurt because of a $28 million payment made by the company over a cybersecurity incident. HCL Technologies’ profitability improved 20 basis points from 19.6% to 19.8% while Wipro’s operating margin declined 20 basis points from 16.2% to 16%.

Investors are pleased when companies can rein in their expenses.

However, the four companies are expected to grow at their slowest pace in the current financial year ending in March. Both TCS and HCL are expected to grow at best at 5% while Infosys's full-year growth will be less than 3%. Wipro, whose shares have seen the biggest jump in the last 75 days, will see its full-year revenue decline by at least 3.5%.

Excited analysts and investors argue that the next financial year (April-March 2025) will be better than the current fiscal year.

But this is more hope than any fundamental metric suggesting that that will indeed be the case.

Let us take two key metrics that your writer has relied on over the last two years to evaluate the health of the sector.

One is the sluggish growth of the three “Hyperscalers” from Silicon Valley. During the pandemic period, IT services firms were able to piggyback on Microsoft Azure, Amazon Web Services, and Google Cloud. Twich+ analyzed the growth at the three cloud computing firms in November last year.

Second is the muted hiring.

TCS has seen its workforce decline from 613,974 at the end of December 2022 to 603,305 at the end of December 2023, a fall of 10,669. Infosys has cut its staff from 346,845 to 322,663 during the last 12 months, a decline of 24,182. Wipro has seen its headcount decline from 262,109 at the end of December 2022 to 240,234 at the end of December 2023, a decline of 21,875. HCL is the only large company to have bucked the trend and has expanded its workforce from 222,270 at the end of December 2022 to 224,756 at the end of the latest quarter, an increase of 2,486.

Unfortunately for investors, both metrics don’t suggest any significant uptick in demand or cheer for the sector.

Finally, the forward price-to-earnings ratio, which tells how expensive a stock is, suggests that the four companies are now richly valued and are more expensive than at any time in the last three years.

The stock market is indicating that the worst is probably over for the large IT firms. But Twich+ would like to remind investors of the timeless market joke: The stock market has predicted six of the World’s last five recessions.

Forecasting is fraught with risks, but I believe this share rally will not end well for many investors.

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Written by Varun Sood. Edited by James Mathew. Produced by Shad Hasnain. Send in your feedback to shad.hasnain@partner.htdigital.in.