Growth, margin uncertainty likely to impair recovery in IT stocks

Scaling up of new deals and lowering costs are imperative for the up to 33 per cent gains in share prices to sustain

The stocks of top IT companies, which were also hit following weak investor sentiment post Covid-19 outbreak, have bounced back sharply from their lows in March. Tata Consultancy Services, Infosys, HCL Technologies and Wipro have seen their share price gain between 23-33 per cent since March 23. Tech Mahindra (TechM) is up by just 10 per cent due to a relatively poor performance in March quarter (Q4). With this, most of these top IT stocks are now trading above or at par with their respective historical 1-year forward valuation mean (see graph).

While the recovery in these IT stocks is partly explained by the rebound in benchmark indices (Nifty50 is up 29 per cent during the same period), favourable risk-reward, wherein valuations fell to below long-term average, also helped lift investor sentiment. However, according to some analysts, the uncertainty regarding growth and earnings poses risk for IT stocks.

Amit Chandra, analyst at HDFC Securities, says, “Further expansion in valuation multiple of top IT players looks challenging given the fluid situation. Rather, companies’ ability to recovery in growth and earnings would be key for the stocks henceforth.” The demand environment, however, is still muted and uncertain, he adds. In fact, Aniket Pande of Prabhudas Lilladher foresees a de-rating of the stocks. “We believe despite coordinated efforts, solid balance sheets and resilient free cash flow there can be a bit more de-rating of IT sector multiples given growth uncertainty,” Pande said in his recent report.

It is largely known that April-September 2020 or H1'FY21 performance of IT companies is likely to be impacted by Covid-19-led supply and demand pressures. The latter, however, would continue to play spoilsport even in the second-half of FY21 (October 2020 to March 2021). Fewer deals wins, delay in ramping up of existing deals and likely price cuts are key worries expected on the back of subdued demand, thanks to disruption in the global economy. Wipro had also highlighted the above mentioned demand concern. According to some analysts, there is a higher correlation (85-90 per cent) between clients' growth and that of domestic IT companies and it impacts order flows with time lag of around 1.5-2 quarters; the impact, however, differs across companies.

Sectors such as banking, financial services and insurance (BFSI), retail and manufacturing are reeling under pressure in terms of business decline, high leverage and lower demand. This would keep a tight lid on discretionary/IT spending by clients in these sectors, which account for 57-68 per cent revenues of top domestic IT companies excluding TechM. Though most IT companies have reported strong new deal wins in Q4, ramping up of deals or deal execution is likely to get delayed as clients are seen conserving cash amidst uncertain times. This could directly taper top-line growth as new deal wins are key contributor to additional revenue growth, Chandra of HDFC Securities cautions.

While deal renewals from existing clients, which accounts for around 90 per cent of IT companies’ revenues, offers volume comfort, it could come at the cost of lower pricing, thereby restricting top-line growth and hurting profitability. Pande of Prabhudas Lilladher believes that margins will likely face strong headwinds from drop in utilisation, pricing cuts and revenue decline. This would also offset any gains from rupee depreciation. Thus, how the companies optimise their costs to protect margins and how work from home brings new growth opportunity, as some predicts, are key monitorables.

For now, investors are recommended to wait till clarity on growth and margin emerges.