Valuation pressure

Outlook for the IT sector has changed considerably

The underperformance of information technology (IT) stocks in the recent past has been an unpleasant surprise. The Nifty IT index has lost over 10 per cent in the past month, with huge sell-offs by disappointed investors as the Q4 (and full-year) results arrived. This is despite reasonable results, and advisories indicating fair performance over the next six months. The root causes of the pessimism are more about the correction of unusually high valuations, and a downgrade in long-term prospects for the sector. The IT industry delivered supra-normal performances over the entire Covid period. Companies adopted new work-from-home protocols, in addition to an acceleration of already existing trends of digitising business models. This meant a combination of strong deal-wins and new revenue streams for IT services.

Until the Ukraine war broke out, 2022 was expected to see corporations continuing to adopt digitisation as the global economy grew. A weaker rupee was also expected to fatten rupee-denominated revenues. The Ukraine war, however, drastically altered growth expectations as supply chain issues and commodity inflation emerged. Companies are seeing slowing revenue growth, margin headwinds, and weak macro environments. All this means a downgrade in valuations of IT companies, since it will lead to the postponement of discretionary spends, and lower tech budgets. Slower digitisation also gels with one of the negative trends investors have noted in Q4, which is the paucity of big, new deal wins. In addition, the past several quarters have seen IT firms complaining about tighter margins and a greater churn, and both those factors are also adversely impacting profits. Infosys, for instance, experienced a sell-off due to lower operating margins in Q4, and TCS also failed to meet profit expectations. Every IT major admits it is struggling with a churn, or “attrition”. Gartner has reduced its global forecast of calendar year IT spending, which is now expected to grow at 4 per cent (versus 5.1 per cent earlier) and it expects specifically the IT services segment to grow at 6.8 per cent (versus earlier expectations of 7.9 per cent).

Given the focus on North America, which delivers over 70 per cent of Indian IT revenues, there is also a strong correlation between the returns of Indian IT companies and returns in the US S&P 500 Index. Consensus estimates suggest S&P 500 revenue growth will moderate to 8 per cent, year-on-year (YoY), in calendar year 2022 and moderate again to 5 per cent YoY in 2023, from a high growth rate of 17 per cent in 2021. As a result of these broader trends, brokerages and investment houses have started to downgrade earnings prospects for Indian IT. Given elevated consensus expectations and valuations, the industry is vulnerable to downgrades. Smaller IT firms (Tier-2 as they are known) appear more at risk since they run at valuations 35-40 per cent higher than their bigger Tier-1 counterparts. The Nifty IT index (which covers the 10 biggest listed IT companies) is trading at a current price-to-earnings ratio (past four quarters) of 22, which is still well above the long-term average of 18 for the sector. In absolute terms, the IT industry is still likely to deliver reasonable returns in 2022-23 but the expectations are optimistic rather than reasonable. Investors need to match expectations to the new realities and the share price corrections reflect that process of re-valuation.