IT stocks reel under pressure due to mounting challenges; Should you avoid them? 4 analysts say this

The Nifty IT index fell 3.36% on September 14, ending as the top loser among the sectoral indices even as the market benchmark Nifty50 closed 0.37% lower.

The year 2022 so far has been bad for the IT pack due to concerns over a recession in the US and Europe which are major markets for Indian IT firms.

In case of a recession, the order pipeline for the IT players will shrink which will hit their revenue and profitability.

The Nifty IT index is down 27% till September 14 this year against a 4% gain in Nifty50. Stocks like Wipro, Coforge, Mphasis, Tech Mahindra and Larsen & Toubro Infotech are down up to 40% year-to-date (YTD).

The looming recession is not the only challenge which is keeping the IT stocks under pressure. High attrition, moonlighting and unpredictable remuneration are also adding to the woes of the sector.

Mounting challenges

The primary causes of the IT index breaking more than 25% this year are high attrition, side jobs, and unpredictable remuneration. Every component of the Nifty IT index is in the red this year; largecap IT stocks have witnessed sharp corrections.

The US, the UK and other countries in Europe are major markets for Indian IT firms. In case of a recession, industry experts believe that the demand from those countries will fall significantly which will erode the revenue and margin of Indian IT firms. This assumption seems to have triggered a sharp fall in most IT stocks.

"The growth prospects of the Indian IT companies remain coupled with the markets in the US. Because of the rate hike announcement by the Fed, we need to assess the macro damage that will come through. When the macro is severely disrupted, companies put brakes on their IT spending towards innovation and only the maintenance work will continue. This would be a big risk for Indian IT companies that are already on high valuations," said Arpit Jain, Joint MD at Arihant Capital Markets.

As per a Mint report, India's biggest job portal Naukri.com saw a 10% reduction in job postings from IT services firms in August compared with the year-ago period, marking the first year-on-year decline in 20 months.

Attrition is another huge challenge for the IT sector. As per a PTI report, the net hiring by the top three IT companies -- TCS, Infosys, and Wipro -- crossed the 50,000 mark in the June quarter. While the hiring spree has cheered tech professionals, worry lines have started to emerge among IT employers over unprecedented levels of attrition, rising manpower costs, and issues such as moonlighting (techies taking up side gigs to work on more than one job at a time).

A Mint report said Infosys has cautioned its employees against moonlighting, saying that such activities will lead to termination of the contract.

Should you avoid IT stocks?

While challenges persist for the sector, analysts and brokerage firms still see some value in IT stocks.

HDFC Securities maintains a constructive stance on the IT sector and its preferred picks are Infosys from tier-1 IT and Persistent Systems from mid-tier IT.

"We reckon that margins have bottomed in Q1, with medium-term tailwinds of normalisation in attrition/sub-con, utilisation and pricing. The margin of safety is higher for tier-1s, with valuations at a 5-year average and nearly 10% above the 10-year average (as compared to more than 40% premium end-CY21)," HDFC Securities said in a note.

"Mid-tier IT resilience is reflected in continued growth premium (more than 550bps growth premium of mid-tier IT versus tier-1 over FY22-24E) and nearly unchanged earnings estimate (2% cut versus 6% cut for tier-1 in the last 3 months)," it added.

The brokerage firm pointed out that the IT index P/E multiples are down 30% YTD, with earnings cut of nearly 5%. While the P/E de-rating was led by macro risk on growth (FY24E), earnings cuts were driven by margin cuts as the lead-lag between growth and operating structure normalise.

Mukul Garg, IT analyst- Institutional Equities, Motilal Oswal Financial Services positive about the IT services industry as the long-term demand outlook 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. In our view, 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.

Jain of Arihant Capital Markets said he is not pessimistic about IT stocks despite challenges. Many US companies like Walmart, and Macy's are moderating their IT budgets amid slowdown concerns. As of now especially in the US, there is not much slowdown in secondary sales.

"We believe this is a temporary slowdown rather than a recession. We are not seeing any impact of slowdown for FY23 in the demand for the IT companies. The slowdown concerns are largely for next year. We are advising clients to add stocks like HCL Technologies where valuations are attractive with a change in business strategy. HCL is currently available at 13 times FY24. TechMahindra is also interesting as 5G technologies pick up, this is currently available at 14 times FY24 can be looked for portfolio," said Jain.

Jain believes that attrition has peaked for most IT companies because some companies have deferred part of their bonuses.

Rahul Goud, Research Analyst - Equity Research, CapitalVia Global Research said he does not see any causes of concern in the IT industry.

"We are positive about IT stocks at this time because, even outside of India, if you look at Accenture's earnings or speak to employees there, there is no downturn in the demand pipeline for IT services and I highly doubt there ever will be. Margin pressure will also increase if the USD/INR appreciates," said Goud.

"TCS, Infosys, and Wipro are preparing for a slump following two years of record profits and staggering pay increases. The US recession may cause revenues and attrition in the IT sector to decline. However, a hypothetical slowdown would be advantageous for lower attrition and lower wage costs. Slower revenue growth may reduce wage increases and attrition rates as well," said Goud.

The sector may be a good bet for the long term, but for the short term, some analysts are cautious about the sector.

Deepak Jasani, Head of Retail Research, HDFC Securities said till we get confirmation about the resumption of growth in order flows (in terms of size and total), he will cautious about the IT sector.

"There is some slowdown in decision making by enterprises in Europe-Manufacturing. The labour crunch is still a challenge but easing supply-side (offshore). Sub-contracting costs may remain elevated. The startup space has been poaching the IT workers, though because of the funds crunch, this has reduced of late. Some IT workers also want to work from home which a lot of employers may not be comfortable with. Hence, despite demand growth slowing down, we still continue to see attrition (though the pace has slowed lately)," said Jasani.

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.