Tier-2 IT firms face sharper downgrades with clients likely to pare spends

Margin pressure and valuation premium point to downside for stocks

Long-term investors in the IT industry are bracing for potential downgrades. Although there should be good growth through the next 6-12 months, the industry may be over-valued, especially the second tier.

There are headwinds that could lead to tighter margins and lower long-term demand. Customers across industries may pare IT budgets as commodity inflation, wage inflation (in the US), tighter monetary conditions and reduced consumption reduce their own revenue growth. The expected growth in 2022-23 may already be priced in, while a likely slowdown and downside risks in 2023-24 may not be reflected.

These negatives could mean valuation downgrades for smaller IT firms and Tier-2 companies. Tier-2 companies are on average, running at valuations which are 35-40 per cent higher than their bigger Tier-1 peers and this differential may be unsustainable.

On the positive side, a falling rupee and strong US growth could be beneficial and digital transformation continues to be a big theme. While Tier-1 companies should be able to maintain their EBITDA margins, revenue growth in constant rupee terms may slow down.

In broad terms, Gartner estimates global IT spend in CY 2022 will grow at around 4.2 per cent YoY instead of earlier estimates of 5.1 per cent. Specifically IT services spending may grow at 6.8 per cent instead of 7.9 per cent. The visibility of big new deal wins in Q4 2021-22 is low, which could be an indicator of slowdown.

The Nifty IT index is trading at a 1-year forward PE average of 28 times and a current PE (past four quarters with most firms yet to declare Q4) of 33.5 times. This is well above the long-term average of 18 times (one year forward earnings) and while the premium over  historic valuations is understandable, given pandemic-driven digital transformation, it also make the IT industry vulnerable to downgrades.

Indian IT revenue growth has always been well-correlated to revenue growth in the US S&P 500. This is explained by the preponderance of North America exposure.  Consensus estimates suggest that S&P 500 revenue growth will moderate to 8 per cent YoY in CY 2022 and moderate again to 5 per cent YoY in CY 2023, from a growth rate of 17 per cent in CY 2021. Even more broadly, US GDP (nominal) is expected to grow at 9 per cent in 2022 and 5 per cent in 2023, versus 10 per cent in 2021 and these expectations could be further pared due to the tighter monetary policy. Both of these broad indicators suggest a moderation of IT revenue growth especially in CY 2023.

While advisories remain positive in the short term, earnings growth guidance are lower, and in macro-terms, slowdowns look likely. The Ukraine War has definitely hurt global growth by creating a fresh set of supply chain problems and energy and commodity inflation issues. Couple that to wage inflation pressures and the Fed’s decision to tighten money supply and global growth is likely to slow considerably below Jan 2022 (pre-Ukraine) estimates.  The IT index has returned 33 per cent in the past 12 months but it has dipped 4.6 per cent in the last month.