Earnings-equity valuation gap of Indian IT companies widens, shows data

The Nifty IT index rose by 5.14 per cent on Friday, marking its best performance in a day since July 2020, followed by another 1.9 per cent rally on Monday. With this, the index, which tracks the share prices of India’s 10 biggest information technology (IT) services companies, has increased 7.1 per cent in the past two sessions. However, the substantial rally in the index occurred at a time when India’s four largest IT companies reported their worst quarterly performance in over five years.

This has resulted in a huge gap between the IT companies’ equity valuation and their financial performance. The numbers indicate a long-term decline in the revenue growth and earnings before interest, taxes, depreciation, and amortisation (Ebitda) margins of the big four, in contrast with a steady rise in their price-to-earnings (P/E) multiple in recent years.

The combined net profit of TCS, Infosys, Wipro, and HCL Technologies was down 1.5 per cent year-on-year (Y-o-Y) in the December quarter. 

This marked their worst earnings performance since the January-March 2018 quarter when their combined earnings were down 2.1 per cent Y-o-Y. For comparison, the combined quarterly net profit of the big four has declined on a year-on-year basis only three times since Tata Consultancy Services’ (TCS’) initial public offering and listing on the bourses in 2005.

 

This excludes the March 2015 quarter when TCS’ net profit had declined by 30.7 per cent Y-o-Y due to a one-time special bonus paid to its employees.
 

The top four IT firms account for 84 per cent of the market capitalisation (mcap) of all 10 companies that are part of the NSE Nifty IT Index.
 

Similarly, these top four companies’ combined net sales were up just 2.4 per cent Y-o-Y in Q3FY24, marking their worst performance since the June 2015 quarter when their combined net sales were up just 2.2 per cent Y-o-Y.
 

The big four IT companies reported a combined net profit of Rs 24,208 crore in Q3, down from Rs 24,581 crore a year ago and Rs 24,032 crore in Q2FY24. In comparison, their combined net sales inched up to Rs 1.5 trillion in Q3FY24 from Rs 1.46 trillion a year ago and Rs 1.48 trillion in Q2FY24.
 

A poor earnings show by these, coupled with a sharp rally in their share prices, has resulted in a wide gap between their financial performance and their equity valuation.
 

After Monday's rally, the top four IT firms are now trading at a trailing P/E multiple of 29.1 times, the highest in the past seven quarters and up from 25.8X at the end of December 2022 and a low of 24.1X at the end of March 2022. The combined mcap of the four IT companies in our sample is up 20.6 per cent since December 2022 compared to 6.7 per cent Y-o-Y growth in their combined trailing 12 months (TTM) net profit and 8.6 per cent Y-o-Y growth in their TTM net sales during the period.  
 

Their combined mcap has now increased to Rs 28 trillion, up from Rs 23.24 trillion at the end of December 2022 but still down 4.2 per cent from the record high of Rs 29.96 trillion at the end of December 2021. These companies reported a TTM net profit of Rs 96,241 crore at the end of Q3FY24. A stock P/E multiple is calculated based on its TTM earnings. 
 

Analysts attribute the recent rally in IT stocks, despite poor earnings growth, to investors’ expectations of better earnings growth in the future. “There is a feeling that the worst is over for the Indian IT industry, and there would be an improvement in earnings from here on, stemming from gains in operational leverage and a string of large deal wins by leading companies in recent quarters,” said Dhananjay Sinha, co-head of equities & head of research-strategy & economics at Systematix Group.

He said the overall net sales and net profit of the top four IT companies in Q3 were slightly better than the market’s earlier estimates, fueling a buy-in these stocks.
 

Others, however, said there was no fundamental basis for this rally. “The recent rally in IT stocks, despite poor earnings growth, is purely because of speculation, high liquidity in the markets, and the entry of a record number of new retail investors,” said G Chokkalingam, founder & CEO of Equinomics Research Pvt Ltd.