IT stocks have been under pressure of late. After giving healthy returns for five consecutive years, Nifty IT has declined over 29 percent from its 52-week high of 39,446.70.
Even as the rupee fell to a record low of 78.20 against the US dollar which is usually positive for the IT sector, NiftyIT is near its 52-week low of 27,423.80 as inflation in the US and European Union raise concerns over the sector’s revenue growth.
Analysts fear rising inflation and aggressive rate hikes may trigger a recession and the IT stocks will see their demand scenarios shrinking.
Akhilesh Jat, Category Manager - Equity Research of CapitalVia Global Research is of the view that the ongoing global macroeconomic uncertainty and soaring inflation could trigger more aggressive rate hikes by the US Federal Reserve which could possibly result in a recession in the US economy in the next 12 months. In Jat's view, the Nifty IT index may underperform in 2022.
As Punit Patni, Equity Research Analyst, Swastika Investmart points out, the IT sector has seen a major correction in recent times due to the tapering down of growth expectations, margin pressures, and supply-side issues, and the recent sell-off in tech stocks globally has further exacerbated the issue.
The recent record-high inflation numbers will compel central banks globally to be aggressive in rate hikes and liquidity tapering which may lead to a slowdown in global economic growth and a recession in developed regions like America and Europe, the major customers of Indian IT companies.
Patni believes that this will led to reduced technology spending and a growth slowdown for the IT sector. He agrees, that there could be turbulence in the short to medium term, but the long-term outlook is positive.
"We are positive about IT companies catering to and having a focus on specific industries, operating in niche areas, and generating revenues in fields like cloud computing, SaaS, etc.," said Patni.
At present, the sector is facing three major challenges- a higher attrition rate, global recession risks, and the de-rating of the sector after a sharp run-up in the last two years.
However, some analysts contradict this view and believe strong demand and other long-term growth drivers are intact for the IT sector.
"With the favourable exchange rate and gradual easing of supply-side challenges, the sector is likely to deliver good growth again in the medium to long term. Deal pipeline is strong for all global IT majors, while we also expect the order flows to remain steady despite the near-term slowdown in the US economy," said Mitul Shah, Head of Research at Reliance Securities.
Shah said some of India’s leading IT companies have witnessed a 50 percent jump in their employee headcounts between FY19 and FY22. The companies went on a hiring spree chiefly in FY22 to capitalise on a decadal growth opportunity.
The industry is seeing continued demand and is likely to deliver good growth on the back of cloud migration and digital transformation. Moreover, a favorable exchange rate would cushion margins going ahead. The recent correction in the IT space bringing down its valuation close to the historical average makes case for valuation comfort.
"On the back of healthy growth, strong deal wins and valuation comfort, we remain positive on the sector. We like Infosys at a valuation of 20.5 times FY24E earnings," said Shah.
The US tech labor market is tight with unemployment rate of 2.1 percent in May. The strength in demand is at odds with the deteriorating macro data points. A few software companies such as MongoDB have also alluded to weakening of demand in certain pockets viz: SMB segment in Europe, Kotak Securities highlighted.
However, as the brokerage firm said, the enterprise client segment addressed by IT companies viz F1000/G2000 companies continues to spend aggressively. The only possible pocket of weakness for now is the mortgage segment due to rising interest rates.
Kotak says a profit warning from clients of IT companies and increasing external risks make the assumption of 6-8 percent global IT spending growth, unreasonable. So, the brokerage firm has moderated its stance and bake in normalized global IT spending growth of 3-4 percent for 2023 and 7 percent for 2022.
"We cut our FY2023-FY2025E revenue estimates by 2-10 percent for our coverage universe. We cut fair value by 5-12 percent. Infosys, HCLT and Mphasis continue to be our top picks," said Kotak.
The road ahead
There are a plethora of opportunities available for the Indian IT players.
As Chirag Kachhadiya, Lead IT Analyst, Ashika Institutional Equities pointed out there are opportunities and new high-growth areas like cloud migration, digital, Web 3.0, artificial intelligence, metaverse, machine learning, automation, 3D-printing, manufacturing, electric vehicle, renewables and blockchain technologies, etc. along with existing work.
Kachhadiya said Investors should consider the current correction as an opportunity to accumulate, and add to existing position as sector leaders from 3-5 years' horizon.
As the brokerage firm Kotak Securities points out that the current phase of the IT sector is intriguing where the attention has shifted towards recession scenarios even as current demand is extremely strong.
"Building on our recent notes, we detail the current state of demand, potential client behavior in a slowdown, difference in the current cycle versus the past and impact on fair values. We moderate our estimates for FY2023-24E and continue with the base case of a slower demand environment," said Kotak Securities.
In case of a recession, Kotak said that the impact on companies will depend on whether it is a shallow recession or a deep recession.
If a recession becomes reality, it will be in the midst of massive systems and tech upgrade cycle. Kotak expects IT spending growth to remain above normalized levels as clients progress towards the transformation journey, even as there may be an odd year or two of below-trend level growth.
In each recession in the past, the business models of India-heritage vendors were dismissed as either labour arbitrage (dot.com bubble burst recession and global financial crisis) or not being digital enough (Covid 19 recession) and Kotak said those concerns have been made redundant by India heritage vendors through constant evolution in capabilities, large-scale localization programs and success in digital transformation programs without losing sight of creating a strong value proposition for clients in traditional services.
Kotak expects IT stocks to bottom out at higher multiples than in the past recession. "Downsides to the current stock prices range from 10-35 percent with the highest downside in L&T Technology Services and lowest downside in HCL Tech. We believe that stocks will bottom out at 18-20 times EPS for sector leaders," said Kotak.
Disclaimer: The views and recommendations made above are those of individual analysts or broking firms and not of MintGenie.