“We suffer more often in our imagination than reality" - Seneca.
Even though the Nifty IT index has corrected nearly 25 percent just since April, brokerage house Edelweiss most of the price correction in the sector are mostly done and the global macro-concerns have already been factored in.
As per the brokerage, IT stocks valuations have corrected 17-49 percent and stock prices have corrected 9-42 percent in the last 6 months (since mid-Dec 2021). Meanwhile, the Nifty IT index valuation has corrected by 27 percent and price by 21 percent.
"About 2 quarters back we made a case that valuation drivers have peaked, now looking at the same drivers we believe that valuations are in a reasonable band now (though at the upper end of the band, rather than lower). For example, Infosys is now trading at 23x 1yr Fwd EPS and 21x 2y Fwd EPS, which given the pre/post-pandemic change in RoCE to 38 percent% in FY22 from 32 percent in FY20 looks reasonable," explained the brokerage.
However, the brokerage added that it believes the bulk of margin pressure is pending. Margin pressure-related concerns are already reflected in guidance/commentary and have led to street estimates cut post-Q4FY22 results (March quarter), noted Edelweiss. Therefore, the revenue estimate cut was 2-4 percent in most cases but the EPS estimate cut was up to 7-9 percent, Edelweiss pointed out.
In the quarter gone by, the concern in revenues was mainly due to macroeconomic conditions. In addition, considering global inflation, lower-than-expected revenue guidance and lower utilization prompted led to a decline in revenue and margins estimates by most brokerages.
Considering the rising interest rate, the anticipated slowdown in the global economy and profit warnings by global corporate has prompted experts to take a cautious view on revenue growth. In addition, in terms of margins headwinds like wage hikes, higher travel and visa cost and lower utilization to negatively impact margins.
As per Edelweiss, 2 of 3 legs – 1st leg, margin related and 2nd leg, cost-of-capital related - price corrections are mostly done. "Yield gap (between 10Yr G-Sec yield and IT index earnings yield) is now at last 12 years (post-Lehman crises) average level. It may undershoot, but at least it’s now at a reasonable level (v/s 5-8 months back)," said the brokerage.
Meanwhile, the third leg (revenue growth cut related leg) is likely to play out over an elongated period (Q2FY23 onwards), it added.
"We believe, revenue cut related earnings impact is still pending which may play out elongated period. The consensus estimate is building 12-17% revenue growth for large caps and 16-22 percent growth for mid-caps. In the near-term, we do not expect revenue guidance cut in post-Q1FY23 results and we believe management commentaries may become cautious but more likely to re-iterate the strong demand outlook. So, in the near-term there is a trading opportunity, though too early to say all is well," explained Edelweiss.
Based on valuation correction and expected likelihood of broadly unchanged guidance/commentary in Q1FY23, Edeweiss' preferred pick to play IT stocks in near terms is Infosys and Tech Mahindra among large caps. Among mid-caps preferred picks are L&T Infotech and L&T Tech. Under volatile/uncertain scenarios, it prefers large caps or large mid-caps over small caps.