Experts say IT stocks not as cheap as they appear

The bellwethers of Indian Information and Technology space – Tata Consultancy Services (TCS) and Infosys – have started the September quarter results season on a sombre note. The two firms witnessed divergence in revenue growth with TCS’ revenues missing Street estimates by a mile, despite most analysts toning down their expectations to factor in the revenue warning issued by the company. And, Infosys managed only a minor improvement on expectations.

The key negative, however, was the increasing caution in the outlook provided by both companies. Infosys, for instance, trimmed its guidance for the second consecutive quarter and the TCS management remained non-committal on growth improving in the coming quarters. This seems to suggest that there could be pain ahead for these companies and the sector on the whole.

The Indian IT sector is going through a transition as it re-aligns its business model to the digital model adopted by global peers. Digital business encompasses IT services catering to cloud, data analytics, automation, artificial intelligence, internet of things and other segments. While digital is the big growth driver for the industry, it is a meaningful shift away from traditional services and has relatively smaller deal sizes as well as tenures. This means there will be increased volatility and unpredictability in the revenue growth of Indian firms. The macro headwinds emerging from Brexit (the UK’s exit from the European Union) and any unfavourable outcome (stricter Visa norms) after the US presidential elections are other risks adding to the uncertainty and restricting growth visibility for Indian IT companies.

This explains the caution and uncertainty in the firms’ commentary. Another factor working against the Indian companies is the fact that they are the incumbents this time around and their global peers adapted to the digital way of life much before Indian companies did. So, unlike the last big growth wave of offshoring, which was led by Indian IT companies, this time the disruption has been caused by global technology companies leading to higher competition for domestic firms. Weak growth in the US is also a concern.

“We see no respite for demand, as macro indicators show demand worsening with contraction in US PMI in August and weak client financials across segments. The commentary across companies suggests demand issues in BFSI (banking, financial services and insurance) and health care, though not restricted to just these verticals,” says Ashwin Mehta of Nomura. “We expect Europe to pull back due to the slowdown in its BFSI sector,” he adds. Notably, the slowdown in the retail industry for both the IT giants in the September quarter indicates that there may be a broad-based pullback in IT spending, analysts say.

In this backdrop, most leading brokerages are cautious on the sector, with some such as UBS Securities not having a buy call on any IT company. Gautam Chhaochharia, head of India Research, UBS Securities, says, “We have an underweight stance on the IT sector because of the disruption Indian IT services companies are witnessing from adoption of digital globally. Mid-cap IT firms are niche in nature, so the impact will vary accordingly.”

However, there are some experts, such as Gautam Trivedi, MD and CEO of Religare Capital Markets, who believe those looking to invest in the sector can consider Infosys, given its undemanding valuations.

However, there are concerns that a lot of this transitory and macro pain is not well-baked into IT companies’ current valuations. Surendra Goyal, head of India equity research at Citi India, for instance, believes there are a lot of challenges for the sector in the medium term and it is not as cheap as it appears.

“Our expectation on revenue growth has come off and earnings growth is likely to be in mid-single digits in FY17 and FY18 for TCS. Furthermore, with looming macro uncertainties, the stock could test its 2011 trough multiple of 15 times,” say analysts at Morgan Stanley in a post results note on TCS. At current levels, the TCS stock trades at 17.8 times FY17 estimated earnings.

“Despite year-to-date underperformance of CNX IT versus Nifty, aggregate tier-1 IT valuations around 16 times one-year forward earnings are not cheap enough to ignore demand or margin issues. Hence, we recommend staying selective and backing a better business mix,” adds Mehta of Nomura.

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