The current phase of the IT sector is intriguing where the attention has shifted towards recession scenarios even as current demand is extremely strong. The IT industry has witnessed one of the best growth momentums in FY22. However, experts predict that in FY23, the IT industry may face a slowdown in its growth momentum, primarily due to supply-side constraints, higher attrition rate, and unfavorable macros (potential slowdown in North America). The biggest fear that has been haunting investors is that, will a possible recession in the US discount the Indian IT services sector and not harm its growth.
Even after US Fed Chair Jerome Powell tried to soothe nerves by saying that “we’re not trying to induce a recession now”, the market wasn’t convinced enough. Heavy sell-off was witnessed across sectors and the IT sector touched its 52-week low in Thursday’s session. Nifty IT index also slipped to a 52-week low of 27,067.45. t has already lost one-third of its value year-to-date. Infosys is down 26 per cent YTD, Tech Mahindra 45 per cent, Wipro 40 per cent, and TCS 15 per cent.
Punit Patni, Equity Research Analyst, Swastika Investmart Ltd., said: “IT sector had been the biggest wealth creator post the pandemic, and the huge investor interest in this sector had made it expensive in terms of valuations. Finally, the beginning of the rate hike cycle and the rising possibility of a recession in developed nations has led to the de-rating of this sector.”
Fed Rate Hike Cycle – A Concern for Investors
North America currently faces 40-year high inflation, so the Federal Reserve has decided to increase the rate hike going forward. Omkar Tanksale, Senior Research Analyst, Axis Securities, said: “Rate hike will pull out excess liquidity from the markets, aiding potential slowdown in businesses across verticals. This development will lead to less automation spending across verticals or delayed ongoing projects in the forthcoming quarters.”
Patni further said that “The USA and other developed nations are the biggest clients of Indian IT companies, and the current rate hike cycle is expected to be a severe and a prolonged one, markets expect a hard landing post this rate hike and a very high chance of a recession in the aforementioned regions. This will affect the purchasing power of businesses and curtailment of IT spending.”
In FY20-21, Infosys earned more than 97 per cent of its revenues from exports. More than 67 per cent of its revenue came in US dollars, hinting at the dominant role which the US market plays in its balance sheet. The picture is no different for most other IT majors.
Even though the current demand environment remains extremely strong, Kotak Institutional Equities said profit warning from clients of IT companies and increasing external risks makes the assumption of 6-8 per cent global IT spending growth, unreasonable. “We moderate our stance and bake in normalised global IT spending growth of 3-4 per cent for CY2023E and 7 per cent for CY2022E. We cut our FY2023-FY2025E revenue estimates by 2-10 per cent for our coverage universe,” it said in a note to the client.
Turbulence In The Short to Medium Term
Analysts think that unfavorable macros from North America (which is the major contributor to the overall industry revenue) will likely impact automation spending in the forthcoming quarters.
Tanksale said: “The higher attrition rate and rising employee and travel costs may impact margins in the near term. These parameters mainly impact the valuations, and we see corrections in the stocks. However, there are a few tailwinds that will help to gain some momentum, like the depreciation of the rupee, robust deal pipeline, and higher demand for offshoring.”
Experts predict that there could be turbulence in the short to medium term and the sector is expected to remain under pressure. Another point to note is that even post the recent correction, IT stocks remain expensive and there exists a possibility of further correction, they added.
What Should Investors Do?
Patni said: “We can’t simply brush off the importance of digitization, cloud computing, machine learning, ease of scaling up, and cost optimizations using technology. This sector has witnessed a structural change post the pandemic and the demand outlook remains robust from a long-term perspective. The companies in this sector are cash-generating machines and characterized by high return ratios, in short, they are long term compounding machines.”
Top Picks
“Investors should not panic as the demand scenario still remains intact, and the stocks will likely gain momentum as these constraints will sort out in a couple of quarters. One should invest in value stocks with higher growth and lower valuations,” said.
“We are positive about IT companies catering to and having a focus on specific industries, operating in niche areas, and generating revenues in fields like cloud computing, SaaS, etc. Our top picks are TCS Ltd., KPIT Ltd., and Intellect Design Arena Ltd.,” Patni added.
Turbulence In The Short to Medium Term
Analysts think that unfavorable macros from North America (which is the major contributor to the overall industry revenue) will likely impact automation spending in the forthcoming quarters.
Tanksale said: “The higher attrition rate and rising employee and travel costs may impact margins in the near term. These parameters mainly impact the valuations, and we see corrections in the stocks. However, there are a few tailwinds that will help to gain some momentum, like the depreciation of the rupee, robust deal pipeline, and higher demand for offshoring.”
Experts predict that there could be turbulence in the short to medium term and the sector is expected to remain under pressure. Another point to note is that even post the recent correction, IT stocks remain expensive and there exists a possibility of further correction, they added.
What Should Investors Do?
Patni said: “We can’t simply brush off the importance of digitization, cloud computing, machine learning, ease of scaling up, and cost optimizations using technology. This sector has witnessed a structural change post the pandemic and the demand outlook remains robust from a long-term perspective. The companies in this sector are cash-generating machines and characterized by high return ratios, in short, they are long-term compounding machines.”
Top Picks
“We are positive about IT companies catering to and having a focus on specific industries, operating in niche areas, and generating revenues in fields like cloud computing, SaaS, etc. Our top picks are TCS Ltd., KPIT Ltd., and Intellect Design Arena Ltd.,” Patni added.
Axis Securities’ top IT Secor picks are Infosys, Tech Mahindra, and Persistent Systems.
The views and investment tips by experts in this News18.com report are their own and not those of the website or its management. Users are advised to check with certified experts before taking any investment decisions.
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