Analysts see robust demand, margin squeeze for IT firms; prefer large-caps

Despite being a seasonally weak quarter due to furloghs and lower billing days on account of holidays, most companies in the information technology (IT) sector reported a strong set of numbers for the October – December 2018 period of financial year 2018-19 (Q3FY19). Analysts attribute the performance to favourable demand environment, execution of early deal wins and currency tailwinds.

Data wise, top five Tier-1 IT companies reported revenue growth in the range of 1.8-5.6 per cent on sequential basis and 7-13 per cent year-on-year (y-o-y) on constant currency (CC) basis. And this is reflected in their stock performance as well. Thus far in calendar year 2019 (CY19), stocks of most IT companies have rallied up to over 14 per cent. The Nifty IT index has moved up nearly 11 per cent thus far in CY19, as compared to nearly 5 per cent rise in the Nifty50 index, ACE Equity data show.

Among individual stocks, shares of Infosys and Wipro have risen over 14 per cent while those of NIIT Tech and Tech Mahindra soared 13.69 per cent and 12 per cent, respectively. On the downside, Infibeam Avenues have fallen over 30 per cent. 

Company Name	Date	Closing price as on Feb 8	Date	Closing price as on Jan 1	% change
Infosys Ltd.	08-Feb-2019	760.90	01-Jan-2019	665.05	14.41
Wipro Ltd.	08-Feb-2019	372.70	01-Jan-2019	326.65	14.10
NIIT Technologies Ltd.	08-Feb-2019	1309.15	01-Jan-2019	1151.50	13.69
Tech Mahindra Ltd.	08-Feb-2019	805.55	01-Jan-2019	719.10	12.02
HCL Technologies Ltd.	08-Feb-2019	1068.45	01-Jan-2019	959.85	11.31
NIFTY IT	08-Feb-2019	16019.80	01-Jan-2019	14450.90	10.86
Tata Consultancy Services Ltd.	08-Feb-2019	2061.40	01-Jan-2019	1902.80	8.34
Mindtree Ltd.	08-Feb-2019	891.55	01-Jan-2019	863.40	3.26
Oracle Financial Services Software Ltd.	08-Feb-2019	3731.90	01-Jan-2019	3729.45	0.07
Tata Elxsi Ltd.	08-Feb-2019	904.50	01-Jan-2019	1026.75	-11.91
Infibeam Avenues Ltd.	08-Feb-2019	33.00	01-Jan-2019	47.45	-30.45

Data source: ACE Equity

But for how long these gains will continue?

Analysts expect the strong performance of Indian IT companies to continue going into the next financial year; however, margin pressure courtesy increased onsite cost structure may take some sheen off. That apart, unfavourable risk-reward ratio given the recent run-up, headwinds emerging from slowdown in the US, uncertainties around the Brexit deal and US-China trade war may adversely impact the Indian IT sector in FY2020, they say.

Maintaining a cautious stance on the Indian IT services sector, global financial services firm Nomura said the sector continues to face structural challenges i.e. higher exposure to slower-growing legacy, competitive pressures (MNCs, challengers, tier 2 and insourcing), margin pressures (pricing led/limited operating leverage) and external risks (protectionism). 

"Macro weakening could outweigh cyclical improvements while valuations still build in continued demand strength. Our pecking order: Cognizant, HCL Tech (Buy), Tech Mahindra, Wipro, Infosys (Neutral) and TCS (Reduce)," it said. 

“The pressure point on profitability is resulting largely from shortage of talent in the US combined with challenges on procurement of fresh visas and even renewals of existing ones. As a result, reliance on subcontractors has increased in the US to fulfil demand inflating costs in the process. We expect this headwind to continue in FY2020E,” wrote analysts tracking the sector at Kotak Securities in a recent report.

Echoing similar view, Amit Chandra, IT analyst at HDFC Securities, says large deal wins announced by TCS and Infosys is a proof that there is a robust demand environment for the Indian IT sector.

“In fact, the demand environment at present is best in the last three-four years. However, problem remains on the supply side. Increased onsite cost structure may boost expenses and hence dent margins. That said, companies have started hiring now, which is adequate evidence that the demand is improving,” Chandra adds.

Stock strategy

Most analysts prefer large-cap IT companies over their mid-cap peers and suggest investors be selective as regards the mid-cap IT names. Strong business model strength and to be consistently in the top quartile on growth parameters are key factors to check before investing.

Among the large-caps, TCS remains the analysts' favourite, followed by Infosys, HCL Technologies and Tech Mahindra.  Among midcaps, Larsen & Toubro Infotech (LTI), NIIT Tech, Hexaware and Mindtree are investment worthy, analysts say.