Valuations for IT players at lower levels to forward EPS on PEG basis

Accenture's results points to sustained growth trajectory

The IT sector could be a hedge against the generally worsening macro situation for the Indian economy. It has a reverse correlation with the rupee. If the rupee weakens, the IT industry gains since the earnings are primarily in hard currencies while a large proportion of its expenditures are in rupees. The industry has also gained from the trend towards digitisation forced by work from home, the movement towards cloud-based services, dematerialisation among others.

Both the growth rates and guidance by companies have remained robust, despite the Ukraine war and the associated negative impact on global growth rates. There is an industry consensus that the demand is not just pent-up spending, which was deferred in the early stages of the pandemic. The move towards digitisation is sustainable for the medium-term. In constant rupee terms, the IT services industry could log 12 per cent revenue growth for the next fiscal and beyond. While most IT firms have complained about margin pressures and high churn, these may be stabilising and pricing improvement is possible in the medium-term if US growth remains strong.  

While the Nifty is down marginally in the last month, the IT Index is up by 2 per cent. The IT Index is much more highly valued than the Nifty 50 however, and the Nifty itself is also objectively quite highly valued. The IT index is trading at a price to earnings (P/E) ratio of 35 times (last four quarters) whereas the Nifty is at 22 times. The premium valuation over the general market is easily justified, given the protection hard-currency earnings and growth visibility offers. It is more speculative to judge if the current valuations over-value the likely earnings growth. However, the market is clearly assigning higher valuations and upgrading FY 2022-23 prospects for the industry.  In comparison to other major sectors as well, the IT industry has seen better post-covid valuations and rerating.

One analysis makes an interesting point about valuations. In terms of P/E, the IT index was trading at 20 times in December 2019 (pre-Covid levels). It is trading at 35 times now. However, EPS annual growth over 2019-2021 ran at around 11 per cent. But EPS CAGR is expected to improve to around 22 per cent between 2021-22 (base) and 2023-24. So the sharp rise in valuations may be justifiable if the valuation is done in terms of PEG (Price Earnings to Growth). Indeed, in terms of PEG, the IT sector is now trading at a lower valuation to expected forward EPS. Midcaps are also trading at premiums to the large caps.  

The US-listed Accenture, which is in many respects comparable to Indian IT service companies has just released strong quarterly results and guidance. Outsourcing revenue grew strong (+2.3 per cent qoq, +19 per cent YoY) along with robust outsourcing bookings ($8.7bn, +17.6 per cent QoQ). Accenture upgraded its FY22 revenue growth guidance yet again to 24-26 per cent YoY in local currency, which is a huge growth estimate. Growth was good across all regions and segments. By comparison, the guidance of Indian peers appears conservative.

In the last month, the best performers among the Indian Nifty IT index include Infy (up 7.5 per cent), Wipro (+7 per cent), LTTS (+4 per cent) and TechM (+3.95 per cent). Only TCS (down 3.7 per cent) and Coforge (down 2.5 per cent) are losers.  Investors could expect faster growth from the mid-sized firms but there would be greater safety in the larger IT service companies.