Notwithstanding a decent set of numbers by top players and optimistic commentary by some IT players, the sector is grappling with both growth and margin issues. Investor expectations from the IT sector may have to be toned down and there could be pressure on sector valuations.
Analysts at Nirmal Bang Institutional Research in their recent report after September quarter results highlighted the possibility of a valuation de-rating for the sector due to growth headwinds.
Banking, financial services and insurance (BFSI) and retail are key verticals for most top Indian IT players and these segments collectively account for 30-48 percent of revenues. According to Aniket Pande, analyst at Prabhudas Lilladher Research, “BFSI and retail are unlikely to improve in the near term given the weak global situation. This, along with margin headwinds, would negatively impact IT stocks.”
Managements of many IT players, which have announced their September 2019 quarter (Q2) results, so far, clearly underlined the issues in the US capital market, large European banks, and the retail sectors in these regions. The management of Tata Consultancy Services (TCS), in fact, sounded cautious about the overall growth in the near term.
In Q2, companies experienced moderate growth in these segments. However, strong growth in the insurance sector and softer base of the June 2019 quarter lifted the overall BFSI growth, on a sequential basis, for some companies. On a sequential basis, while TCS and Infosys (excluding Stater acquisition) posted up to 1.3 percent rise in the BFSI vertical, Wipro continued to report de-growth. In the retail segment, the top two players — TCS and Infosys —posted up to 1.4 percent sequential decline.
Pande expects some moderation in the manufacturing sector given the feeble US-PMI print. After a 10-year low print of 47.8 percent in September, Institute for Supply Management’s US PMI index continued to remain weak in October at 48.3 percent. Purchasing Manager Index or PMI below 50 percent indicates a contraction.
Though some companies showed robust deal wins in Q2 and Infosys upped its revenue growth guidance marginally for FY20, the caveat is the slower pace of deal conversions. “Deal conversion is taking time in certain pockets. Factors such as global slowdown delaying IT spends and talent shortage are hurting the deal conversion rate,” says Amit Chandra, analyst at HDFC Securities.
Besides, there is no relief from margin pressure for IT firms yet. As observed in the past two-three quarters, subcontracting cost and attrition are worrisome and these will weigh on margin and the earnings growth outlook. Though some companies like Infosys witnessed 120 basis point sequential improvement in Ebit (earnings before interest and tax) margin in Q2 to 21.7 percent, the jury is still out whether the improvement will continue.
Notably, growth and margin worries being discussed since the past couple of quarters are now getting reflected in stock prices of IT companies with their ‘defensive’ nature in question. The Nifty IT index gained less than a percent over the last month, sharply underperforming 7 percent rise in the Nifty50 during the same period. Investors, thus, should be selective as many stocks are still trading at up to 18 percent premium to their respective historical long-term valuation average. HCL Tech is analysts’ top pick in tier-1 players for now.―Business Standard