The stocks of top IT companies, which were also hit by weak investor sentiment post the Covid-19 outbreak, have bounced back sharply from their lows in March. Tata Consultancy Services, Infosys, HCL Technologies and Wipro have seen their share prices gain between 25-36 per cent since March 23. Tech Mahindra (TechM) is up by 13 per cent due to a relatively poor performance in the March quarter (Q4). With this, most of these top IT stocks are now trading above, or at par, with their respective historical 1-year forward valuation mean (see graph).
While the recovery in these IT stocks is partly explained by the rebound in benchmark indices (Nifty50 is up 29 per cent in the same period), favourable risk-reward, wherein valuations fell to below long-term average, also helped lift investor sentiment. However, according to some analysts, the uncertainty regarding growth and earnings poses risk for IT stocks.
“Further expansion in valuation multiple of top IT players looks challenging given the fluid situation. Rather, companies’ ability to report recovery in growth and earnings would be key for the stocks henceforth,” said Amit Chandra, analyst at HDFC Securities. The demand environment, however, is still muted and uncertain, he added. In fact, Aniket Pande of Prabhudas Lilladher foresees a de-rating of the stocks. “We believe despite coordinated efforts, solid balance sheets and resilient free cash flow there can be a bit de-rating of IT sector multiples given growth uncertainty,” Pande said in his recent report.
It is believed that April-September 2020 or H1FY21 performance of IT companies is likely to be impacted by Covid-19-led supply and demand pressures. Demand pressures, however, would continue to play spoilsport even in the second-half of FY21 (October 2020 to March 2021).
Fewer deals wins, delay in ramping up of existing deals and likely price cuts are key worries expected on the back of subdued demand, thanks to the disruption in the global economy. Wipro had also highlighted the above mentioned demand concerns. According to some analysts, there is a higher correlation (85-90 per cent) between clients’ growth and that of domestic IT companies and it impacts order flows with a time lag of around 1.5-2 quarters; the impact, however, would differ across companies.
Sectors such as banking, financial services and insurance (BFSI), retail and manufacturing are reeling under pressure in terms of business decline, high leverage and lower demand. This would keep a tight lid on discretionary/IT spending by clients in these sectors, which account for 57-68 per cent revenues of top domestic IT companies, excluding TechM. Although most IT companies have reported strong new deal wins in Q4, ramping up of deals, or deal execution, is likely to get delayed as clients conserve cash amidst uncertain times. This could directly taper top-line growth as new deal wins are a key contributor to additional revenue growth, Chandra of HDFC Securities cautions. The domestic business too, is seen slowing.
While deal renewals from existing clients, which accounts for around 90 per cent of IT companies’ revenues, offers volume comfort, it could come at the cost of lower pricing, thereby restricting top-line growth and hurting profitability. Pande of Prabhudas Lilladher believes that margins will likely face strong headwinds from a drop in utilisation, pricing cuts and revenue decline. This would also offset any gains from rupee depreciation. Thus, how the companies optimise their costs to protect margins and how work from home brings new growth opportunity, as some predicts, are key monitorables.
For now, investors are recommended to wait till clarity on growth and margin emerges.