At first glance, it appears that the IT sector is at a critical juncture.
The outlook for the sector is hazy amid strong concerns over a recession in the US and Europe. Analysts and investors are finding it difficult to foresee a clear trend for the near future. However, some believe most negatives for the sector are already factored in.
A strong wave of pessimism has engulfed the sector. Some tech companies are laying off people in thousands and have frozen new hiring.
As per media reports, net hiring in India's top software exporters declined to the lowest level in 11 quarters in the December 2022 quarter.
"India’s top four software exporters — Tata Consultancy Services, Infosys, HCL Tech and Wipro — together recorded a net addition of 1,940 employees in the quarter ended December 2022, the lowest in 11 quarters, as demand for technology services slows amid global macroeconomic uncertainty and geopolitical concerns," an Economic Times report said.
IT majors, such as TCS, Infosys and HCL Tech witnessed a fall in attrition rate during the December quarter. As per industry observers, the IT sector attrition has softened from peak levels of 25-30 percent in the previous year to about 20 percent in Q3FY23.
The worst yet to come?
The sector, which witnessed strong tailwinds during the times of the Covid-19 pandemic, seems to have hit rough weather.
The December quarter scorecard of top domestic IT firms such as TCS, Infosys, Wipro and HCL Tech came broadly on expected lines, however, the management sounded cautious about the coming few quarters.
TCS management talked of "slow" decision-making in Europe and said it is "fairly constructive" when it comes to markets like the US, although it is keeping a close watch on how things play out over the next couple of quarters.
Infosys raised its annual sales forecast on a strong deal pipeline, but in the same breath, it warned of "constraints" in specific verticals amid the slowing global economy.
Anmol Das, Head of Research, Teji Mandi, is of the view that the next couple of quarters will remain tough for the IT sector due to the expected slowdown in their dominant clients' segments, such as the BFSI.
"High-tech companies on cost-cutting drives. Although deal wins have been consistent for TCS and HCL Tech, and at an all-time high for Infosys, we believe that a few larger and mega deal wins in the coming quarters will help these stocks to pick up the pace," said Das.
Some analysts and brokerage firms believe most negatives for the sector are on the table and after the first quarter of the next financial year, things will start changing for the IT sector.
Kotak Institutional Equities does not think the situation is as bad as it appears for the IT sector. It pointed out that the sectors' Q3FY23 results were slightly better than feared.
Kotak highlighted that revenues of tier-1 IT companies came in above expectations in Q3FY23, with the exception of Wipro. It was aided largely by an increase in pass-through revenues.
"Revenue growth has slowed down to low-teens across companies and should move down further in the subsequent quarters. However, the deterioration is consistent with our estimate. The medium-term revenue growth picture remains unchanged," said Kotak.
"Guidance for Q4FY23E was muted among tier-1 IT with the exception of HCL Tech, which guided for 1.5-3 percent growth. However, the guidance was much better than the feared revenue decline across companies," it added.
The brokerage firm underscored that the IT stocks are at an interesting juncture—moderate upside if it is just a slowdown in developed economies, moderate downside in case of a recession. Kotak said a recession view for the developed markets, which was a consensus a few months ago, still holds but with reduced intensity.
Kotak expects a double-digit EPS (earnings per share) increase for the Indian IT industry in rupee terms in FY24E, aided by 7 percent revenue growth, margin expansion and rupee depreciation.
Kotak believes lower industry growth due to a deeper recession can be offset by higher rupee depreciation and margin expansion, leading to largely unchanged EPS estimates.
The road ahead for the sector
There are strong headwinds for the sector in the short term. In simple words, the IT sector does not look suitable for short-term traders at this juncture.
However, the long-term drivers are still there and that is the reason many analysts and brokerage firms still show faith in the sector.
"Deal bookings have been steady in Q3 which provides near-term growth visibility. The elements of macro volatility result in growth for the IT sector moderating to pre-Covid even as the long-term drivers are unchanged. While the revenue trajectory for the sector will moderate from 13.5 percent growth in FY23 to 8.5 percent in FY24E, the profit growth trajectory in FY24E will improve as supply side crunch eases," said Apurva Prasad, Institutional Research Analyst - IT, HDFC Securities.
Das of Teji Mandi believes most negatives for the sector are priced in but one has to be selective about the sector in the next one-two years.
"One has to be very selective among the bunch as in the next one-two years, we don’t expect any sectoral tailwind driving valuations up for all IT services players," said Das.
What should investors do?
Investors can pick quality stocks from the IT sector for a long-term horizon. Analysts and brokerage firms expect the sector to come into focus once the dust about a recession in the key markets settles.
Brokerage firm Kotak prefers stocks that offer good growth potential and can participate in both discretionary spending as well as cost take-out initiatives of clients and are available at reasonable valuations.
"Infosys and HCL Tech fit the bill among tier-1 IT. The correction in quality mid-tier stocks can make them attractive. Mphasis is our preferred pick among mid-tier names," said Kotak.
Das does not see much downside for the larger IT stocks in the next couple of quarters, so he recommends holding IT stocks at the current levels.
However, Das added that with growth prospects in mind, one should be selective among the IT pack as sector leaders will be charging ahead of others before the scenario improves.
Abhishek Jain, Head of Research, Arihant Capital, is positive on the largecap IT stocks.
"Among the IT sector, largecap stocks are better suited for the environment and they have a certain pricing power. We continue to remain positive on largecap stocks, on the back of stronger order books, and built-up bench strength. On the deal-win side, they will be much more stronger than midcap and smallcap companies," said Jain.
"We are positive on Wipro, and Coforge among the larger IT players. Post results, one can definitely have a look at Tech Mahindra among the large caps on 5G adoption. In the midcap and smallcap space, one can look at Accelya Solutions India and Axiscades Technologies on weakness (not at current levels). Allied Digital Services also looks interesting," Jain said.
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.