IT stocks: Double-digit growth required to justify high valuation multiples

Over the last 3 months, the Nifty IT index has gained a whopping 35 per cent, almost 6 times the rise in the Nifty50

The stellar listing of Happiest Minds Technologies last week once again underlines investors’ focus in IT stocks thanks to the increasing thrust on digital infrastructure because of the Covid-19 pandemic.

In fact, the story isn’t different for established players either. Over the past three months, the Nifty IT index has gained a whopping 36.2 per cent, about 5 times the rise in the Nifty50, which is up 7.4 per cent over the period.

Thus, at 21.5 times financial year 2021-22 (FY22) estimated earnings, the Nifty IT index is currently trading at about 29 per cent premium to the Nifty50. Notably, the sector’s current 1-year forward price-to-earnings (P/E) ratio of 23 times is 38.5 per cent higher than its 5-year mean.

Many analysts do not see a sharp downside risk to IT stocks, they also feel IT companies need to clock double-digit growth over the medium term to justify such high valuation multiples. “We believe IT firms have strong growth levers in place, led by a strong deal pipeline, mainly in the digital space, and this would help sustain valuations,” says Suyog Kulkarni, analyst at Reliance Securities. 

Sanjeev Hota, head of research at Sharekhan, echoes the view. He says, “We expect most leading IT companies to register double-digit growth over FY20-FY23 and this would justify their current valuation levels. Increasing weighting of IT in the Nifty is also driving the re-rating. A strong deal pipeline and likely higher IT spending across the sectors point towards strong growth potential for IT players.”

While current valuations suggest the Street is factoring in high sustainable growth in the long run, it also implies that growth expectations are higher for mid-tier IT companies vis-a-vis tier-1 players.

The pandemic has clearly shown the necessity of strong digital infrastructure as is seen in the deal wins by IT players. Elara Capital’s recent report on the IT sector, based on commentary from 18 IT firms, highlighted that the pandemic has led to increased adoption of cloud services and client-buying behaviour is changing as they move faster on digital.

Accenture’s August quarter results, announced on Thursday, also suggests strong traction for Indian IT players. While the company guided for 2-5 per cent revenue growth for FY21 (it follows September to August financial year), its expectations of high single to low double-digit growth in H2FY21 (March-August 2020) paints a bright FY22 outlook for Indian firms, say analysts at PhillipCapital. The news boosted the Nifty IT index, which was up 3.5 per cent on Friday versus 2.3 per cent rise in the Nifty50.

What is also noteworthy is that Indian players’ capabilities have also been improving, further adding to the growth expectations. Amit Chandra, analyst at HDFC Securities, underlines that the market share of Indian firms in the global IT market has increased from 5-6 per cent to around 27 per cent in the past 15 years and gains have intensified over the last five years. He feels improved payouts by IT companies are also supporting valuations.

The higher payout clearly signals strong free cash flow generating ability. Even in the past, tier-1 players’ payouts as a percentage of free cash flows increased from 62 per cent in FY17 to 121 per cent in FY20 and from 45 per cent to 77 per cent for mid-tier players.

The upcoming presidential election in the USA in November will also have an impact on Indian IT firms, as North America is the largest market.

Overall, how the IT players cash in on growth opportunities and how their deal pipeline pans out would be very crucial. For now, investors are advised to remain selective. Infosys, Tech Mahindra, HCL Technologies, and L&T Infotech are analysts’ top picks.