IT stocks’ recovery may hit growth, margin hurdles

Expansion of new deals, reduction in costs key for share price gains to sustain

Stocks of IT majors, which were severely hit by weak investor sentiment after the Covid outbreak, have bounced back sharply from their March lows.

TCS, Infosys, HCL Tech, and Wipro have seen their shares gain 25-36 per cent since March 23. Tech Mahindra (Techm) has risen 13 per cent, on account of a relatively poor showing in the March quarter (Q4). With this, most of the top IT stocks are now trading above, or at par, with their respective historical 1-year forward valuation mean.

While the recovery could be attributed partly to the rebound in the benchmark indices (Nifty up 29 per cent during the period), a favourable risk-reward scenario — wherein valuations fell below the long-term average — also helped lift sentiment. However, according to some analysts, the uncertainty regarding growth and earnings poses risks.

Amit Chandra, analyst at HDFC Securities, said: “Further expansion in the valuation multiple of top IT players looks challenging, given the fluid situation. Rather, firms’ ability to stage a recovery in growth and earnings would be key.” However, the demand environment is still muted and uncertain, he added. In fact, Aniket Pande of Prabhudas Lilladher expects a de-rating. “We believe that despite coordinated efforts, solid balance sheets, and resilient free cash flows, there could still be a slight de-rating of IT multiples, given the growth uncertainty,” he said in a report.

Performance of the sector in H1FY21 is bound to be affected by the Covidinduced supply as well as demand pressure. The latter, however, will continue to play spoilsport even in H2FY21.

Fewer deals wins, delays in ramp-up of existing deals, and likely price cuts are key worries that stem from subdued demand, caused by the disruption in the global economy. According to some analysts, there is a higher correlation (85-90 per cent) between growth of clients and that of domestic IT firms. This impacts order flows with a time lag of 1.5-2 quarters; the impact, however, will differ across companies. Sectors like BFSI (banking, financial services and insurance), retail, and manufacturing are facing pressure in terms of business decline, high leverage, and falling demand. This will keep a tight lid on discretionary/it spend by clients in these sectors, which account for 57-68 per cent of revenues for top domestic IT firms excluding Techm. Though most have reported strong deal wins in Q4, the ramping up of deals or deal execution is likely to see some delay, with clients conserving cash.

This could directly taper top-line growth, as new deal wins are key contributors to additional revenue growth, says Chandra of HDFC Securities. Domestic business, too, is expected to see a slowdown. While deal renewals from existing clients — accounting for around 90 per cent of revenues — offers volume comfort, it could come at the cost of lower pricing, thereby restricting top-line growth and hurting profitability.

Pande of Prabhudas Lilladher believes margins will face strong headwinds due to a drop in utilisation, cut in pricing, and decline in revenue. This will also offset any gain from depreciation of the rupee. Therefore, how companies optimise their costs to protect margins, and how ‘work from home’ brings new growth opportunities (as some predict), are key monitorables. For now, investors should wait till clarity emerges on growth and margins.