IT Sector expectations in Q1FY23

The IT sector contributed 8% of India’s GDP in 2020, or before pandemic. The epidemic first manifested itself in 2021 and continued to have an influence on the world economy. Even during the last two years the IT sector was an outperformer owing to increasing migration of customers to cloud based services and cybersecurity, which was a huge opportunity for the Indian IT industry companies.According to the GoI’s Economic Survey 2021–22, the IT sector
contributed 9.2% of India’s GDP in FY2022.

IT sector companies employs very large number of people every year and that’s why IT industry has such immense importance in Indian economy. While in the past six-month IT industry is one of those sectors which have reported negative returns for the investors owing to several headwinds it is facing. NIFTY IT has fallen more than 26.33% in last six months, with many leading IT sector companies hitting their 52 weeks low.

IT majors such as Tech Mahindra, Wipro, Mindtree, Infosys, TCS and HCL Technologies have retreated between 10% and 45% YTD. According to analysts, IT shares underperformed due to higher odds of a recession in developed markets in the next 12-18 months. This can be better understood through the graphic below:

The corporate result season for India Inc. is set to kick off this week with information technology major Tata Consultancy Services’ earnings on July 8. Now, that Q1 of FY23 has ended, many people expect that IT sector will rebound, and IT sector shares will start delivering positive returns. So, now let’s have a thorough glance at their probable future.

Many brokerage firms are expecting reasonable strong growth in IT sector in Q1FY23

Given the hard financial environment around the world, brokerages predicted in their preview report on the entire IT industry that the first quarter of FY23, or Q1FY23, would be a relatively robust growth quarter for Indian IT sector companies.

Among the top-tier group, Infosys is anticipated to top the growth charts, followed by TCS. HCL Technologies, Wipro, and Tech Mahindra would be impacted by seasonal weakness and company-specific challenges. According to projections, Mindtree and Persistent will continue to lead growth among mid-cap companies.

While the growth projection will be the main focus, margins are anticipated to remain constrained for the next two quarters before beginning to normalise in the IT sector. “Companies are incurring high talent retention costs (retention bonus, out-of-cycle wage revision etc.). The challenge exists, in India as well as onsite.

This pressure will seep into margins; we forecast a 70-400 bp YoY decline in Ebit margin across our coverage universe,” said Kawaljeet Saluja and Sathishkumar S of Kotak Institutional Equity Research. They went on to explain that margin pressure comes in the form of Infosys, TCS, and Tech Mahindra wage revisions, increased travel expenses, and a drop in utilisation as businesses recruit more freshmen.

Margin pressure likely to continue in IT sector due to Wage increment & Travel costs

Concerns over a potential recession in the US and Europe as well as rising inflation throughout the world would cause management comments on the demand projection for the first quarter of FY23 in the Indian IT industry to be closely watched. Because the problems on the supply side have not yet been resolved, higher travel and retention costs will have an effect on profits.

The silver lining, though, could be a falling rupee. Since Indian IT sector companies export these services, a falling rupee is good for them. However, this time, the effect on containing margin compression could not be as significant. The majority of IT companies’ EBIT (earnings before interest and taxes) margins are predicted to decrease in Q1FY23. “Investor focus has shifted to a potential demand slowdown, while IT firms are dealing with a separate challenge i.e., talent shortage to meet demand,” analysts at Kotak Institutional Equities said in a report.

The brokerage issues a warning that the June and September quarters will see the height of margin pressure and
projects a fall in EBIT margin of between 70 and 400 basis points year over year in Q1FY23 for IT sector shares it covers.

Effect on Demand & Attrition rates in IT Industry

Analysts following the market reported that top-tier and mid-cap IT sector companies’ managements have reiterated the strong demand environment brought on by cloud and digital transformation in their most recent commentary. However, many analysts now think that Q1FY23 will mark the beginning of any demand change. “While our recent discussions with management indicate continued momentum in spending on technology services, we expect initial signs of an impact in sectors like retail and manufacturing in Q1FY23,” said an IT preview report from Mukul Garg and Raj Prakash Bhanushali of Motilal Oswal.

Take note that recent analysis by multinational IT powerhouse Accenture indicates that demand conditions are still strong. Strong demand would also result in high attrition rates for the sector, at least in the short term. Indian IT sector companies have been aggressively hiring, particularly freshers, to address this. In general, over the past three years, IT sector companies’ net hiring rate has grown.

Analysts point out that increasing the number of new hires helps IT companies’ staff pyramids and is good for profitability, but the advantages won’t become apparent right away. Price increases may provide margins with additional positive factors.

According to a survey by ICICI Direct Research, price increases have been a topic of conversation between businesses and their customers, and some of them are currently experiencing price increases in some areas. According to the article, any significant price increases are still to come. “We believe IT spends are strategically important but not immune to macro pressures,” ICICI Securities said while maintaining its underweight stance on India IT sector as it sees peak revenue growth momentum behind and thinks that deal and hiring momentum will likely
soften.

Over last six months, the Nifty IT index has fallen by 26.3%. Analysts predicted that the risk of a slowdown in FY24 results, if not a full-fledged recession, would keep IT sector shares under pressure in the near future. It was to be expected that the sharp slump in IT sector shares would result in a drop in their values.

According to Bloomberg statistics, the IT Sector PE ratio (price-to-earnings) multiples for Tata Consultancy Services Ltd, Infosys Ltd, and Wipro Ltd for the fiscal year FY24 are 25x, 21x, and 15x, respectively. IT sector companies PE ratio (Price-to-earnings) could further drop even though their current values appear reasonable in the case of further earnings downgrades.

With the results results season kicking in this weekend and the results of major IT sector companies including midcap IT companies expected by the end of this month, it remains to be seen whether the results reflect the analysts outlook or the IT sector companies surprise with better than expected results paving the way for rise in IT sectors shares from their current beaten down values.

 

About the Author

Ketan Sonalkar (SEBI Rgn No INA000011255)

Ketan Sonalkar is a certified SEBI registered investment advisor and head of research at Univest. He is one of the finest financial trainers, with a track record of having trained more than 2000 people in offline and online models. He serves as a consultant advisor to leading fintech and financial data firms. He has over 15 years of working experience in the finance field. He runs Advisory Services for Direct Equities and Personal Finance Transformation.

Note – This channel is for educational and training purpose only & any stock mentioned here should not be taken as a tip/recommendation/advice

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