Investors in shares of Indian Information Technology (IT) services companies cannot afford to leave the forest for trees with the threat of a global recession.
Margins and revenue growth trends have been two important parameters to assess the financial health of IT service providers. However, in the current backdrop, IT investors should also closely monitor other indicators for more clues on future demand. These include hiring momentum, deal pipeline and revenue growth from top clients.
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“Clients of Indian IT companies start planning their IT spending budget for the next year after September. Therefore, any insightful management commentary on this would be important,” said Kumar Rakesh, a senior automobile and technology analyst at BNP Paribas Securities India.
So far, despite the deteriorating global macroeconomic environment, comments from IT companies have been upbeat, especially on the demand front. True, the impact of changes in global macros is reflected with a lag on earnings. However, with the September quarter (Q2FY23) results, management’s tone may change. “We believe that the disconnect between macro (e.g. weak US and European economies, lackluster demand) and micro (comments from management) will no longer persist,” analysts at ICICI Securities Ltd said in a report on October 1.
Vertical, banking, financial services and insurance (BFSI) and retail account for the top four IT companies’ revenues. Increased digitization after the COVID pandemic boosted the demand for IT from the BFSI sector. However, there is a catch. “IT spending across the top six US banks grew 4.2% yoy (y-o-y) in 1HCY22 (versus 7.3% in 1HCY21) and 5.3% yoy in CY21. This is contrary to the positive BFSI demand narrative,” analysts at Ambit Capital said in a report on October 4.
The bright spot is that the sector’s earnings before interest and tax (EBIT) margin moderated in Q1 FY23. That said, headwinds such as wage revisions, increased travel costs, and higher subcontracting expenses, mean recovery will be gradual. Higher utilization levels, cost rationalization, and Rs depreciation are some tailwinds, but they will offer limited cushion to margins in Q2.
ICICI Securities expects 30-90 basis points (bps) sequential increase in Ebit margin for Tier-1 IT and around 100 bps sequential decline on average for Tier-2 IT. It remains to be seen whether Tier-1 IT companies retain their FY23 revenue growth guidance.
The sector’s migration is expected to peak and companies should begin to decline on an annualized basis. However, hiring may moderate in the coming quarters due to macro uncertainties and general holiday in the December quarter. In view of this, IT investors are quite nervous. The Nifty IT index has fallen 24% so far in FY13, underperforming the benchmark index Nifty 50. The valuation multiplier of the sector measured in relation to price-to-earnings has cooled off of late, but is still higher than the historical average. Some analysts say that there has been a slowdown in the valuation of the IT sector, but not a slowdown. If bearish risk was indeed at play, the valuation could be further corrected.
Ambit analysts said tier-1 and tier-2 IT valuations of 22.6x and 25.2x are still around 24% and a 46% premium over the pre-Covid three-year average. “We expect growth in 2Q results or limited positive surprises on margins. Market expectations on both growth and margins remain high and may moderate post results.
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