IT sector may be ripe for the cherry-picking

The information technology (IT) services industry could see value investors taking selective punts in the near future. While growth remains visible, managements across the board have been cautious or measured in their guidance and have also complained about a combination of margin pressures and high churn.

The two factors are related in that employee compensation is a large component of IT costs and high churn has forced firms to hike compensation packages and also invest more in hiring, training, and retention.

But the valuations of IT companies have also fallen significantly as the industry has underperformed in the broader market. However, the sector valuation at a price-toearnings (P/E) 27.75x is still at a premium to the broader market, with the Nifty at a P/E of 22.5x.

In the past 12 months, the Nifty has returned 7.5 per cent, while the IT Index has declined 14.5 per cent. But the IT Index is up 6 per cent in the past month, which could mean a change in perspective.

Nonetheless, given the global headwinds, investors have to be selective. Cloud adoption and automation are two areas where spending will remain strong. Artificial intelligence/machine learning and data analytics are also likely to be popular.

A sequential look at deal wins to order books shows that only Infosys and HCLTECH have seen very meaningful growth in deal wins in the second quarter of 2022-23 (FY23) versus the first quarter of FY23, while Persistent Systems has seen steady growth year-on-year.

IT firms have highlighted slower decision-making and caution concerning client budgets and lower discretionary spending. IT businesses with lower Europe exposure and even lower consulting exposure will be less at risk, given that discretionary spending by IT customers is likely to see consulting being curtailed and Europe sliding into recession.

The cross-currency impact will also be negative if the euro weakens more against the rupee. The rest of the world, excluding North America and Europe, is also seeing adverse currency trends, with the rupee getting stronger.

Also, the more rate-sensitive the customer base, the more likely that IT budgets will be curtailed. Hence, high banking, financial services, and insurance exposure could result in weaker growth. Analysts also expect attrition and churn to ease, improving margins.

Also, utilisation is expected to improve as trainees start being productive, although aggregate utilisation remains low. There are signs of attrition peaking and margin improvements and management seems confident that utilisation will improve. Hiring/churn could ease.

There’s divergence in trends, with managements citing macro weakness as a common worry but seeing differences in client attitude across verticals and regions. The high-tech vertical is expected to be the weakest in the near term.

In global macro terms, clients in media, telecommunications, and manufacturing have reduced earnings expectations, which could percolate through to IT budget cuts. Energy, however, could be strong since growth expectations are high and the BFSI segment could come through in terms of budgets due to a focus on cost-cutting.

Overall, the IT services industry is expected to see a combination of revenue growth weakness, with slightly improved earnings before interest, tax, depreciation, and amortisation margins compensating for the expectation of lower growth.

Earnings estimates could remain in the same range. Analysts suggest Infosys and Persistent may be among the better bets, while TCS, with its large Europe exposure, and HCLTECH could see revenue weakness.