Talks of a recession in the US have dealt a strong blow to the Indian IT stocks. The Nifty IT index is down 31% as of September 19 this year against a nearly 2% gain in the benchmark Nifty50, thanks to heightened worries that a recession in the US will erode demand for IT services which will put pressure on the margin of Indian IT firms.
But the fears over an impending recession are not the only factor which has weighed on IT stocks. After two splendid years 2020 and 2021, the valuation of the Nifty IT pack was uncomfortably rich. It needed a trigger to cool down which the rate hikes and recession fears seem to have provided.
The sector is also witnessing high attrition which is causing unpredictable remuneration. While demand is slowing, companies are having to spend more on employee retention.
Sticky inflation is likely to cause a prolonged phase of rate hikes which may mean a longer recession. Investors are concerned that the earnings of IT companies in FY23 and FY24 may be subdued. This concern seems to have triggered a selloff in IT stocks.
Is the fall in IT stocks an opportunity for long-term investors?
Value emerging in the IT sector
Some analysts now believe that there is value emerging in the IT sector for long-term investors.
V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services, believes that Nifty IT's steep fall this year is an overreaction to a likely US recession impacting tech spending in the US.
"IT majors have not yet reported any slack in demand and are well set to meet their guidance this year. A rally in IT stocks is likely in October around the Q2 results. The sector may remain weak in the short run until clarity emerges on the likely US recession, but for long-term investors, present valuations offer buying opportunities," said Vijayakumar.
Mukul Garg, IT analyst- Institutional Equities, Motilal Oswal Financial Services has a similar view. He is optimistic about the long-term prospects of the IT services industry and highlights that the long-term demand outlook for the sector remains intact.
"While the companies might see some near-term moderation in growth due to weaker macro environment in key-end markets, the drag should be muted due to increased focus on technology adoption across industries. It is unlikely that both demand slowdown and elevated attrition can co-exist. In case the demand moderates, the pressure on supply would start easing out over a period," said Garg.
The next two quarters may be challenging for the sector owing to the economic slowdown in the US and Europe. But this may not sustain long as the dependence on IT-enabled services has risen sharply after the pandemic which means the long-term demand scenario is intact.
"The next two quarters would see consolidation and the sector may face challenges due to the likely slowdown in the US and European markets. However, the long-term positive outlook remains intact as the rate of digitalization, which had picked up on account of the Covid-19 pandemic, is expected to maintain its momentum," said Piyush Pandey, Lead - Institutional Equities, Yes Securities.
"There can be a temporary pause on the part of enterprises on their IT transformation projects but such projects are unlikely to be cancelled. Also, the slowdown in the US/Europe would support cost optimization efforts by the companies in the US and Europe and it would support outsourcing of IT services," said Pandey.
He thinks that the IT sector presents value for long-term investors with a time horizon of more than two years.
"Most of the margin headwind is behind and the margin tailwinds such as improving employee pyramid, increase in price realization and positive operating leverage would support operating margin over the next three quarters. The employee attrition which remains high but has started moderating would also support the margin going ahead," Pandey said.
In the last few years, Indian IT firms have evolved stronger with the emergence of new segments such as machine learning (ML), cloud services and artificial intelligence (AI). Experts point out that Indian IT firms are going to reap the benefits of these.
Tanusree Banerjee, Co-Head of Research, Equitymaster underscored that India's leading IT companies have reasonably resilient businesses that can bounce back despite temporary technology spending cuts, especially in Western markets.
"What can really work in their favour is the digitalisation and focus on tech innovation in India in the coming decade. Indian companies are now as focused on technology capex as on physical capex. This trend offers a massive tailwind to the key technology players with expertise in AI, ML, blockchain, iOT, cyber security, cloud computing, etc.," said Banerjee.
Since the valuations of several stocks in the IT sector look reasonable from a long-term perspective analysts advise investors with a long-term perspective to go with players having consistency in cash flows and healthy return ratios.
Disclaimer: The views and recommendations given in this article are those of individual analysts and broking firms. These do not represent the views of MintGenie.