Is India’s IT sector on track for revival?

The PE ratios of key IT stocks are at a discount, and the macro concerns in the sector over the next year could materialise and be factored into the price

At the onset of the COVID-19 pandemic, the world tried to cope with ‘work from home’. One sector that benefited from this shift was the IT sector. Increasing digital consumption meant that IT companies had strong order flows, and an abundance of liquidity in the economy meant that higher investments were being made in digitalisation, and cloud computing, as a theme.

However, in the last 12 to 18 months, the tide began to turn for the worse, and the Indian IT sector has had to face considerable headwinds. The global economy was laced with inflationary concerns. As a result, central banks raised their interest rates and squeezed out the liquidity from the financial market. Higher rates hinder a company’s ability to reinvest in innovation and growth opportunities, and slow down its cash flows. Many Indian IT companies provide services to the United States and Europe-based clients, and these macroeconomic challenges for these clients were bound to affect the budget they had for their IT spending.

The US Banking Crisis

In February and March, the US banking environment took a drastic turn when the Silicon Valley Bank announced insolvency. In the weeks that followed, several national and regional banks in the US and Europe collapsed or faced severe strain on their liquidity. The BFSI (Banking, Financial Services, and Insurance) sector is a major revenue contributor to Indian IT companies and, hence, the IT sector faced further headwinds.

Source: Investor Presentations of respective companies for Q4FY23

The current banking situation in US and Europe is likely to have near term impact on IT companies since the clients in this sector are likely to maintain caution and reduce any discretionary spending until the situation stabilises. Hence, there is a possibility that revenue from this sector will be under pressure till the end of this calendar year.

Is Revival In Sight?

It is clear from the Q4 results of the IT companies that customer sentiment across verticals like BFSI, technological services, among others remains cautious and, hence, technology-related spending could be muted in the next few quarters. While the interest rate cycle seems to be nearing its peak and there is hope of a pause in rate hikes in the US, the macro-economic situation in the US and European markets continues to remain uncertain.

Source: Ace Equity

On the margin front, FY23 saw significant correction for IT companies compared to the previous year. Hiring activity was high during FY22 due to anticipation of strong demand. Attrition rates for a lot of IT companies were consistently over 25 per cent. With the macro-economic situation worsening at the onset of FY23, hiring activity has seen moderation. However, the incremental demand will now be met with reasonable ease because of front-loaded hiring practices from prior years, which could lead to a normalisation of salary expenses for IT organisations. This is encouraging for the companies’ margins in FY24.

Read | Nearly 60,000 contract workers lost jobs in India's IT sector: Recruitment body

The guidance for revenue growth, however, has become more conservative in their commentaries for the recent quarter. Companies such as HCL Technologies and Infosys have guided for a 4-8 per cent of revenue growth in constant currency terms for FY24.

Data as of May 15, 2023. Source: investyadnya.in

IT stocks have always traded at relatively lower valuation levels compared to some of the other sectors mainly due to lower expected growth in the sector. However, while analysing individual stocks it is necessary to compare the valuations to historical median ratios as well to get a better understanding of whether the current levels are at a discount or a premium.

Compared to previous valuation levels, the current PE ratios of key IT stocks are at a discount. However, this could mean that the macro concerns in the sector over the next year could materialise and be factored into the price. The uncertainty from the US Federal Reserve about policy rates in the future could mean that the near-term volatility in the sector would be high. As is the case with any investment, an investor must consider their risk appetite and growth expectations before deciding to invest.

Parimal Ade (Twitter: @AdeParimal) is Founder, and Gaurav Jain (Twitter: @gaurav28jain) is Co-Founder, Investyadnya.in.

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.