TCS, Infosys, Wipro, HCLTech: IT stocks rally can get derailed by simple math

There is no doubt the top-tier Indian IT companies are not just the best managed companies in India, but amongst the best globally. Their past track record over the last two decades exemplifies this. So does their size and scale. With the exception of Accenture, it is the Indian companies that dominate the global IT services space. But does that provide a sufficient case for paying any price for their stocks when growth is disappointing?

Thought experiment

What happens when a company continues to reward employees without any improvement in their productivity? It will result in the profit margins of the company getting squeezed. Why? If the increase in salaries per employee is higher than the increase in revenue per employee, all other costs trending in line with revenue, will mean profit margins will have to reduce. If other costs are capped, profit margins may hold for a while, but not for long. This is what happened for the IT companies in FY22 and FY23, when revenue growth was good, but an increase in salaries and subcontracting costs resulted in decline in profit margins, and consequently profits growing slower than revenue.

Investors need to apply this same logic to share price as well. What happens when lower growth is rewarded with higher valuation? May be, at best, stock returns can hold for a while (phase 1), but eventually it will underperform earnings growth (phase 2) and if earnings growth too is low (phase 3) , it can end up being a double whammy for investors in the long run.

For IT stocks, phase 1 has played out well over the last one year as can be seen in the table below, wherein stocks have substantially outperformed earnings growth.

It would be reasonable to make an argument that, if valuations were cheap, then stocks can outperform earnings growth for a while. But then here is some data on how the IT stocks are valued now when growth is weak, versus how they were valued when growth was booming. We have considered the constant currency revenue growth metric here, as operationally, it is one of the most important metrics that provide information on underlying business trends.

And here is another set of data to consider. How the IT stocks were valued when growth was as weak as now in the previous decade.

Looking at these charts, it is quite clear that the growth over the next few years has to be significantly high to justify current valuations. While investors are expressing confidence in this, fundamental data points and only cautiously optimistic management commentary do not support this investor euphoria.

US GDP growth is witnessing a deceleration versus CY23 and recession risks remain for later part of this year or early next year. IT discretionary spending remains weak as per management commentary and can be evinced from recent quarterly results as well. AI impact on IT services companies remains uncertain. While the companies are gearing their investments towards building AI capabilities, how exactly it will disrupt business trends remains unclear.

Even if one were to consider the optimistic scenario that the IT companies will capitalise on the trends as they have during phases of previous disruptions, here is another fact to consider. Much of the digital/cloud revolution in IT services happened during the 2014-24 decade. During this period, the widespread adoption by enterprises of digital and cloud services apart, there was also the Covid-driven accelerated digital spending. During this period, the revenue growth for the top IT services companies was as follows:

In rupee terms, the growth in the previous decade can be considered quite decent. However, it needs to be noted that this came with the benefits of currency depreciation as can be seen from the difference in revenue growth in INR and USD terms. So two things need to be kept in mind here. While AI theme can benefit IT services companies, it may be challenging to repeat the growth of previous decade, given their larger size today. Growth tapers as size increases. Further, whether currency benefits of the previous decade will play out this decade too needs to be contemplated upon.

After the recent upside in IT stocks, the question that arises is: Is the worst over given the stocks’/ Nifty IT underperformance from their prior peak in December-January 2022? Looking at the data above, given current valuations and fundamentals, investors may have to endure a more prolonged phase of sub-par returns.