Further correction in IT stocks not ruled out amid multiple headwinds

Share prices across the information technology (IT) sector have seen sharp corrections. While the Nifty50 has risen 1 per cent in the last month, the IT Index has dropped 5.9 per cent. Many individual shares have done worse. On Wednesday, both the S&P BSE IT and Nifty IT indices were the top sectoral losers, down by over 3 per cent each.

The reason for the recent selloff is the strong association between the IT sector and North America. As US inflation has spiked and the US Federal Reserve (Fed) turned hawkish, it’s assumed the IT sector’s revenues will be hit by a likely slowdown in US demand. In addition, the Europen Union (EU) is going through demand destruction.

In the first quarter for the 2022-23 financial year (Q1FY23), the IT sector saw continuing margin pressures which the managements have been cautioning about for the last three quarters. Attrition continues to be high but there are signs of stabilising attrition, which could help.

The IT industry is seen as a hedge against rupee depreciation. But the Great Britain pound (GBP) and the Euro are weakening, relative to the rupee even as the US dollar strengthens. So IT large-caps, which have a significant Euro exposure, will see lower currency gains, while mid-caps have less EU exposure.

The thesis for downgrades is simple enough but not necessarily accepted by all investors. There is an opinion that demand may be sustained despite the current macro slowdown and inflation, with averaged 8 per cent global growth for IT services. But it’s admitted that labour crunch and churn is a challenge across the board and a slowdown in the EU is visible.

The 2022 calendar year has seen an approximately 5 per cent downgrade to estimated earnings for the Nifty IT (earnings per share or EPS weighted by free float) but the index has fallen 31 per cent since January. Have margins bottomed out or are they close to bottoming out? Investors may see higher levels of safety in large IT stocks where price- to-earnings (PE) multiples are now running at around the five-year average while in mid-caps and small caps are still running at 30-40 per cent premium.

In guidances, TCS sees demand remaining strong in North America despite the inflation but it does see weakness in its EU exposures. Management guidance also implies that attrition is stabilising. Infosys also sees the pipeline of deal wins remaining strong. The European market is less strong and margins are also likely to fall in the short term in the manufacturing vertical. Wipro’s guidance is that margins seem to have bottomed out and the deal pipeline remains in good shape and attrition is moderating.

Tech Mahindra sees potential revenue growth from 5G rollouts but it is still seeing high attrition. L&T Infotech sees European revenues hit by currency issues, and attrition is still high, but it maintains its revenue and margins guidance. Mindtree is noticing challenges in EU and the retail vertical is seeing weakness but it is maintaining margins guidance. Mphasis says that margins will be towards the lower end of earlier guidance.

Given bearish sentiments, there is a chance that IT stocks will continue to trend lower until valuations become attractive but if you trust the guidances, the corrections may already have gone deep enough for selective investment.