Most mid-tier IT companies have put up a dismal performance in the first quarter of the financial year 2019-20 (Q1FY20), nudging brokerages to not only slash target prices for stocks, but also downgrade their ratings.
While the street had factored in margin pressure owing to rupee appreciation, wage hikes and visa costs, the extremely weak numbers from names such as Cyient and Mindtree have taken market participants by surprise. Even the stronger names, such as L&T Technology Services and L&T Infotech, have posted subdued numbers due to weakness in some of its segments. Mastek, too, had a tepid quarter. NIIT Technologies, however, fared better than the rest.
Going by the analysts' view, the IT sector, as a whole, faces four major challenges. Firstly, tough macroeconomic environment, such as trade wars, have an indirect impact on these companies. Due to uncertainties, some companies are taking a longer time to take discretionary and IT spend decisions, thereby affecting revenue realisations. Uncertainty around Brexit also poses risk to the companies' growth.
Secondly, the tide has turned for the rupee, which till last year was depreciating. This has impacted IT companies' profitability.
Thirdly, higher costs in the form of wage hikes and investment in training is also taking a toll on the performance.
Lastly, the non-digital revenue has been under pressure since a long time, and that trend still continuing.
“Most mid-cap and Tier 1 IT companies have seen their non-digital revenue reduce or decline. So, even when digital revenue is rising, say as much as 30-40 per cent YoY, their non-digital is on a decline, leading to tepid overall revenue," says Harit Shah, an analyst tracking the sector at Reliance Securities.
So, what’s the road ahead?
Most experts say the near-term headwinds are likely to stay even though they remain bullish on the long-term prospects.
"After the strong pick-up in growth witnessed through FY18 and FY19, there are some growth headwinds for the sector. The Tier-II tech companies had seen a much sharper growth recovery in the same period and given the operating leverage associated with their financials, they would probably see a much higher impact of the moderation in growth,” said analysts at Emkay Global.
Apurva Prasad, assistant vice-president for research (Institutional Equities) at HDFC Securities is bullish on L&T Infotech and L&T Technology Services. HDFC Securities also has a 'buy' rating on Mastek with the target price of Rs 618.
“Both these companies are durable and will sustain these challenges. In case of L&T Infotech, the company's BFSI (banking, financial services and insurance) vertical awaits recovery while in L&T Tech, telecom and hi-tech divisions witnessed slowdown in this quarter and are a cause of concern in the near-term.”
Centrum Broking has downgraded Cyient to 'Add' from 'Buy', earlier and has lowered the target price by 20 per cent to Rs 560 led by both EPS (earnings per share) downgrade and P/E (price-to-earnings) downgrade (13x FY21E EPS vs 14x FY21E EPS earlier).
Edelweiss Securities, on the other hand, remains bullish on ER&D (engineering research and development) and its demand prospects, and expect Cyient to participate in demand once its client-specific issues are resolved. It has maintained ‘BUY’ with a revised target price of Rs 632 (versus Rs 688 earlier).
Another IT firm Mindtree posted a 41.4 per cent fall in consolidated net profit at Rs 92.7 crore for the quarter. Attrition stood at a seven-quarter high at 15.1 per cent.
“We believe rise in attrition can put execution risk to the total contract value (TCV). Mindtree’s top client accounts to $212 million annualised revenues to the top line (20 per cent), which put higher dependence and risk going forward, says Prabhudas Lilladher. It has a 'reduce' rating on the stock now, with the target price of Rs 755.
Sonata Software is the top pick of Reliance Securities. "The company is focusing a lot on intellectual property, they have good balance sheet quality with no debt. And, also they are trading at good valuations - 11.5-12x FY20 earnings, making it an attractive investment bet," Shah of Reliance Securities says.