scorecardresearchWhat lies ahead for the IT sector: Should you buy mid-cap IT stocks?

What lies ahead for the IT sector: Should you buy mid-cap IT stocks?

Updated: 05 Aug 2022, 08:49 AM IST
TL;DR.

  • The June quarter numbers of the IT firms came on a mixed note. The management of top IT companies is positive about the demand environment in the near term and expects a good deal pipeline.

Cost cutting by US banks is going to hit companies that have greater exposure to BFSI and mortgage services business. Photo: Unsplash

Cost cutting by US banks is going to hit companies that have greater exposure to BFSI and mortgage services business. Photo: Unsplash

At first glance, it appears that the IT stocks have been downhill this calendar year. The sector has been hit due to high attrition, supply shortage, elevated fresher hiring costs which show up in lower utilization, higher subcontractor costs and an increase in discretionary costs such as travel.

In 2022 so far, the Nifty IT index is down 23% while the benchmark Nifty is flat. From their all-time highs, Nifty IT is down 24% while Nifty50 is down 7%.

The June quarter numbers of the IT firms came on a mixed note. The management of top IT companies is positive about the demand environment in the near term and expects a good deal pipeline.

What lies ahead for the IT sector?

A slowdown or a recession in the US and Europe is a real risk for the IT sector. "Even as large US banks sound the caution horn on IT spend amid growing macro turmoil, India IT is sure to feel the after-tremors," brokerage firm Elara Capital pointed out.

"Given that BFSI ( banking, financial services and insurance) is the largest vertical for India IT at nearly 29% as also its unfailing growth engine since the past six quarters, expect the hit to be sweeping," the brokerage firm added.

Moreover, mortgage lending has a strong negative correlation with the interest rate cycle and thus, is the hardest hit sub-segment. Elara highlighted that after Fed’s quantitative tightening (QT), overall mortgage volumes in the US pared 53.5%, as of July 2022.

"Expect an immediate corresponding hit on India IT versus a delayed impact from other sub-segments," said Elara.

Major US banks have expressed their intent for cost optimisation in the near term.

"Wells Fargo (WF), Goldman Sachs (GS) and Morgan Stanley (MS) intend a ‘spend cut’ to fend profit/brew operating resilience. Citi Bank was the outlier given a large transformation project roll-out in June-22 quarter," Elara pointed out.

This is going to hit companies that have greater exposure to BFSI and mortgage services business. Elata Capital believes Wipro and Mphasis with 35% and 62% revenue exposure, respectively, to BFSI and mortgage services businesses, are at risk. Elara has downgraded Wipro (target price: 390) and Mphasis (target price: 1,940) to a 'sell.

The last six months' correction in the IT pack has offered some valuation comfort but the sector appears to be staring at a long-term subdued growth if the US enters into a recession.

"Higher fresher addition and lower sub-contractor expenses should offset the margin headwinds on account of higher employee costs, travel coming back, and visa costs. However, if the US enters into a recession, the order inflow may be impacted to a certain extent leading to subdued growth for a longer period," said Siddhartha Khemka, head of retail research, Motilal Oswal Financial Services.

Kush Ghodasara, Independent Market Expert is of the view that IT stocks are in a time-wise consolidation phase so rather than buying stocks at one go, one should buy IT stocks on dips in part for the next two months.

"The sector is looking ready for a good rally by March 2023," said Ghodasara.

Should you buy midcap IT stocks?

Largecap IT players have the advantage of a wider market share. Since the outlook for the sector has weakened, investors are wondering what should they do with midcap IT stocks.

The Q1 earnings showed an interesting trend that the many midcap IT names have outperformed tier-1 IT players in terms of revenue growth and margin. So, it is better if investors balance their portfolio with a mix of large and midcap IT stocks.

"Mid-tier companies continue to outperform tier-1 IT players on revenue growth by a large margin in Q1FY23. We believe margins have bottomed out for the sector and will improve hereon. Given macro conditions, we scout for companies that offer attractive risk-reward with the balancing of growth potential, vulnerability to slowdown and valuations. Investors should follow a balanced approach and add both largecap and midcap IT companies to their long-term portfolio. In the largecap, our top pick is Infosys and in the midcap segment, one can look at Mphasis and Coforge," said Sumit Pokharna, Research Analyst and Vice President at Kotak Securities.

Analysts said while picking up midcap names, one needs to be cautious and understand the company's current demand outlook and growth prospects.

"In Q1FY23, midcap IT posted strong revenue and profit growth. In fact, few outperformed largecaps , but attrition remains on the higher side and salary hike impact in most midcap will take place after Q1 so margin and other cost pressure will start to kick in. So, Investor has to be very selective in midcap IT space," said Chirag Kachhadiya, Lead IT Analyst, Ashika Group.

Some analysts suggest one should wait till the outlook for the sector improves. As the headwinds wase, the largecaps will be at the front to reap the benefits than the midcaps.

"Firstly, the outlook of the IT sector needs to improve which is still modest due to the risk of global recession and cut in tech spending. Valuations continue to be on the higher side compared to the long-term trends but have corrected from the elevated levels to three-year averages. The pressure on margins from supply side issues is expected to subside in the next quarters considering the increased fresher intakes by companies. This can help the sector to perform well in the short to medium term, which we believe will be triggered first in the largecaps than to midcaps," said Vinod Nair, Head of Research at Geojit Financial Services.

Disclaimer: The views and recommendations are those of individual analysts or broking firms and not of MintGenie.

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