Growth uptick, multiple tailwinds to prop up information technology sector

Weak rupee, expectations of higher IT spending by US clients and undemanding valuations keep frontline stocks in demand

The information technology (IT) indices were the key gainers last week, outperforming the broader markets with a rise of about 4 per cent, led by both large- and mid-cap companies.

The broader markets might see intermediate rallies, such as the one on Monday. However, due to concerns over stiff broader market valuations of 18 times FY19 earnings estimates — mid- and small-caps are significantly expensive — and worsening macro indicators, such as inflation and rising bond yields, investors are looking at the IT sector as a defensive bet. The change in sentiment is also supported by the improving growth prospects of the IT sector.

Tailwinds such as the weakening rupee vis-à-vis the dollar works in the favour of the IT sector. The rupee hit a four-month low against the dollar and is trading at around Rs 65. The weakening of the currency will boost the margins of top Indian IT companies, which earn about 60 per cent of their revenues from the US market, even if a part of the gains are retained and not passed on to customers.

The key trigger, however, is the expectation of a recovery in the sector. The sector has been facing headwinds over the last couple of years, on account of IT budget cuts by key clients, such as those in the US, and its large presence in traditional areas (application development and maintenance) that have exhibited muted growth.

Many domestic IT players were also slow in shifting to newer technologies. For now, the reduction in corporate tax rates, the transition to territorial taxation, and provisions that will require immediate expensing of capex are expected to improve the profitability of US Inc, which will also be starting its capex cycle.

Analysts at Ambit Capital expect the banking, financial services and insurance (BFSI), retail, technology, and communications verticals — estimated to contribute 64-70 per cent of the revenues of firms such as TCS and Infosys — to be the biggest beneficiaries of tax reforms.

While BFSI is the largest vertical for Indian IT majors, muted growth in the banking and retail verticals has affected overall sales growth. The shift in spending to online marketplaces has led to declining sales growth for traditional retailers in the US, which put pressure on IT vendors. However, TCS’s December quarter results indicated the sector might grow in the double digits in FY19.

The gradual increase in deal value for the digital segment might also add to the overall growth of the sector. Indian IT majors have been late entrants into this high-growth area and have been losing out to nimble competitors. With the rise in digital revenues, sales growth is expected to come through.

Analysts led by Sanjeev Prasad at Kotak Institutional Equities expected the profits of the IT sector to recover in FY19 on the back of three triggers — improvement in budgets in the BFSI vertical, the weakening rupee and expected an increase in other income on a low base, given the completion of buyback programmes in FY18.

While business prospects are improving, undemanding stock valuations with average price-to-earnings ratio for FY19 at about 16 times is why brokerages are turning positive on the sector. Analysts said a rise in spending in key verticals and a higher share of digital revenues should help the sector rerate, as was the case with Accenture, which is trading at 23 times its one-year forward estimates from the earlier 16 times.