IT Sector: Even as recession imbibes fear, fundamentals strong, says Emkay

IT sector has corrected 27 percent in 2022 so far, a stark underperformance versus a 9 percent decline in benchmark indices. This recent decline is mainly driven by higher odds of a recession in developed markets in the next 12-18 months.

In a recent note, brokerage house Emkay Research analysed the sector’s performance during the 2008 (Global Financial Crisis) recession and the more recent 2020 pandemic crisis and concluded that it calls for buying into this price rout.

It further highlighted that the shrinking margin gap of Indian IT players against their global IT peers will soon put a floor to the multi-decadal trend of progressively declining sector margins.

It has assigned a 30 percent chance of a global recession.

The brokerage noted that the odds of a global recession cuts target multiples for IT stocks by 13-26 percent, however, it remains confident that the sector will maintain its premium valuations over its pre-pandemic levels. Its top buys in the sector are Infosys, HCL Tech, Wipro, Tech Mahindra, Mindtree, L&T Infotech and Mphasis.

Let's take a look at what the brokerage's analysis of the 2008 and 2020 periods entails:

Revenue and margin behavior contrast with each other: The brokerage noted that the IT sector’s revenue growth shows directional causality to US GDP growth – with a sharp moderation during the 2008/2020 recessions. During GFC, revenue slowdown pre-empted the actual recession by a quarter, while during the pandemic, the decline was in sync, it noted. Further, the revenue rebounded to pre-recession growth rates post-GFC recovery and actually surged higher after the pandemic, it added. The analysis also showed that margins expand during recessions and revert to the mean in the recovery phase.

Stock prices override fundamentals as recession fear sets in and then surge: As per the report, the IT sector underperformed massively by 30 percent a quarter prior to the 2008 recession. However, since during the pandemic, almost all sectors declined simultaneously and thus less relevant here. The key observation, according to Emkay is that the IT sector’s outperformance during the recession and recovery thereafter is stunning. The surprise element pointed out by Emkay, is that the actual EPS estimates in the first and second years of the recovery actually come in about equal or higher than they were before the recession fears set in. In a nutshell, revenue catches up to the pre-recession trend a year or two into recovery, while EPS settles higher, it noted.

Medium-term risk to sector margins is lower than in the past: The brokerage believes that the delivery-led cost optimization gains are largely behind us. As global IT companies gain 100-300 bps in margins over the next several years, it will act as a floor to Indian IT sector margins, added Emkay.

Outlook

The brokerage noted that the Indian IT services exports’ growth has moderated in each of the 5-year blocks in the last 2 decades. The recent pandemic-led accelerated digitization and cloud traction are expected to arrest this declining trend with FY22-FY27E IT services export CAGR expected to be higher than the preceding 5-year CAGR. It also expects the IT services spend to rise in the coming years on account of growing tech intensity, higher digitization and cloud adoption. However, a potential macro slowdown may impact near-term growth, it added.

Emkay expects IT services stocks to maintain their premium valuations compared with the pre-Covid period, considering multi-year digital and cloud growth opportunities, improved capital allocation, and growing tech intensity across industries driving growth faster than global GDP growth.

Rating changes

The brokerage reinstated MindTree and L&T Infotech to Buy with target prices of ₹3,400 and ₹4,700, respectively, at 25x Jun’24E EPS, taking into account attractive valuations after the recent corrections and benefits from merger synergies in the medium term.

TCS’s stock performance has remained resilient in the last six months, however, due to the relatively expensive valuation after factoring a 30 percent probability of recession, Emkay downgraded it to Hold.

Its pecking order stands as follows: Infosys, HCL Tech, Wipro, Tech Mahindra, and TCS among Tier-1 names; and MindTree, L&T Infotech, Mphasis, Firstsource Solutions, Persistent Systems, Route Mobile, Birla Soft, and eClerx Services among mid-caps.