‘Wu ji bi fan’ as Jacki Chan says in Karate Kid, that is, when things reach an extreme, they can only move in the opposite direction. As did the IT stocks and Nifty IT Index after peaking in a frenzy in early 2022. However, in the last one year, they have attempted a strong recovery piggy-backing on the AI theme, and Nifty IT is now 6.5 per cent above the 2022 peak. It is not clear though if this will sustain. While recent Q2 results indicate the slowdown may have bottomed out, the pace of revenue growth still remains underwhelming.
For example, the Big 5 in global IT — Accenture, TCS, Infosys, HCLTech and Wipro — reported September 2024 quarter (August quarter for Accenture) constant currency revenue growth of 3, 5.5, 3.3, 6.2 and 2.3 per cent, respectively. This is a far cry from 15, 15.4, 18.8 15.8, 6.5 per cent, respectively, they had reported for the September quarter of 2022. Thus, recent results are no cause to celebrate.
Re-rating stays
The Covid driven digitisation boom set in motion a short-term spurt in growth that resulted in a significant re-rating in the IT sector. But pretty soon that growth fizzled out with companies like Infosys reporting one of its lowest growth years ever in the last 20 years in FY24. Nevertheless, many investors have stayed put at the counter expecting a quick revival. Valuations continue to remain at the top end of the historical range.
From pre-Covid years, the PE ratio of TCS, Infosys, HCL Tech and Wipro have been re-rated upwards by 29 per cent, 37 per cent, 105 per cent and 43 per cent, respectively. To the contrary, their operating performance has deteriorated when compared to pre-Covid FY19. So even while growth has tapered off after spurting in FY22 and FY23, valuations have stayed put.
Across the companies revenue growth is weaker. Margins, too, have declined compared to FY19. Even these current margins have been on a tight leash on expenses — headcount reductions/higher utilisations and lower marketing and travel costs as percentage of sales. So one can make a case that scope for operating margin improvement is likely only if business booms (unlikely for now) and at the same time companies can keep headcount costs in check. But FY23 proved the cost of high growth in IT sector is lower margins.
End game
Lower growth, lower margins, but higher valuation. This is the risk that investors in IT stocks need to watch out for. Amidst AI disruption and uncertain US economy, growth is unlikely to pick up meaningfully. With 48-60 per cent revenue from the US for top four IT players in India, and some serious economic slowdown in Europe (other major geography), growth overhangs remain. Growth in markets like India, can provide some succour but are not big enough to offset the impact.
When it comes to margins, the aspirational operating margin targets of IT majors continue to remain elusive for a nearly a decade after they were conceived of by managements of companies like Infosys and TCS. For all the revenue growth and digital and cloud transformation boom of last decade, margins have declined.
So it is highly likely that valuation is what will break the impossible trinity in IT sector. Just that the FY25 performance can be marginally better than FY24 is not a sufficient case for the current valuations to sustain.
What should investors do?
It is better to expect muted returns in IT stocks from here on and if exposure is required, investors must stick to companies which have relatively better margins and have had a lower degree of re-rating. From this standpoint, while it is anybody’s guess on the absolute direction of stocks from here, one can infer HCLTech and Wipro could be relative underperformers.