IT stocks rally on core market pick up hope but is the sector out of the woods yet

• In the last month, hopes of US business revival pushed up the Nifty IT index by over 9%.
• While markets see it as an ‘inflection point’, most analysts choose to wait and watch before going for earnings upgrades.
• Margin performance of large companies is impressive but cracks appear in mid-tier, say analysts.
  

Shares of IT services companies have been gaining momentum, with the Nifty IT index rising by 9.7% in the past month. While the sector’s earnings growth dwindled in the third quarter (Q3) of the current financial year (FY24), top tier companies delivered better than expected earnings reading with a healthy margin performance.

The top six IT companies reported a -1.7% to 6% constant currency growth sequentially in Q3, and their margins improved due to operational performance.

“Margin performance emerged as another positive. That helped arrest earning downgrades for top-4. Market possibly took this as an inflection, spurring sentiments, reflected in 7% up move in Nifty IT year-to-date. We however believe earning upgrades won’t be as forthcoming,” said a report by J M Financial.

Markets upbeat, but BFSI recovery crucial

The market, nevertheless, is upbeat on the sector with the top three players giving double digit returns in the last one month. The Street is betting that the improved outlook on the US macroeconomic situation might lead to spillover gains for the Indian IT majors.

A report by Systematix ‘Indian IT poised for an inflection’ says that the top three players may see revenue recovery FY25 onwards, boosted by continued deal momentum.

“Indian IT companies trading at higher than historical valuations reflect the structural positivity beyond the near-term uncertainties. Hence, the possibility of numbers turning better than the current projections holds the possibility of further rerating,” says Systematix.

However, this upbeat sentiment is not shared by all the sector experts. As of the latest earnings report, most companies continued to suffer from slow revenue conversion from deals, furloughs and more.

Even if the much anticipated interest rate cuts pan out this year, the US companies’ performance does not offer too much hope of them reinstating their IT budgets, a few insist.

J M Financial says that S&P 500 companies’ revenue upgrades have been minimal, and especially low in consumer discretionary, hi-tech and telecom sectors. It reflects continued cost optimization.

Moreover, in the banking and financial sector, which is key for the IT companies, there is still pain.

“The pick-up in FY25 is highly contingent on banking and retail. Turning to financial results and commentary from large banks, we are not optimistic of a major surge in spend by banks. Hence, our growth forecast for FY25 remains in the range of 6-7%,” said a report by HSBC.

Source: NSE

Cracks in the mid-tier

If at all there is demand revival, the top four companies like TCS, Infosys, Wipro and HCL Tech are best placed to gain from it. While the top tier rationalized costs, mid-tier companies like LTTS, Mphasis and LTI Mindtree had missed earnings estimates in Q3.

“As demand has softened, mid-tier IT services have begun to struggle on profitability. We think this pressure may remain in the short term until demand picks-up meaningfully, which is unlikely, in our view,” said HSBC which added that ‘mid-tier is now showing cracks’.

New deal wins were also mixed for mid-tier companies, unlike their larger counterparts where it was robust. Coforge, LTIM and Persistent had good deal wins in Q3, Mphasis’ deal win total contract value came in weak at $241 million.

Hyperscalers, large cloud service providers, have shown positive results for the quarter. “While that gives hope for better downstream demand, we need to see if that results in net new demand or mere reprioritisation of IT budgets,” said J M Financial.

In spite of exuberance in the stock performance, most analysts are choosing to ‘wait and watch’ before they build their expectations of the IT sector's recovery.