Regulatory changes, margin pressure likely to weigh on IT stocks

The sustained pressure on margin, along with Gartner’s recent note highlighting lower global information technology (IT) spending going ahead underline the growth pressure for domestic software players and potential risk of earnings downgrade.

Of late, post the June quarter (Q1) results, many analysts have cut their FY20 earnings estimates for Tata Consultancy Services (TCS) by 2-3 per cent due to the above-mentioned concerns. Some like Elara Capital also changed the ratings downward from Buy to Accumulate for TCS.

Though demand pressure is palpable for the past one or two quarters, it was pronounced in the June quarter. JM Financial says that TCS attributed its revenue growth miss in Q1 to incremental issues in the BFSI (banking, financial services and insurance) and the retail sectors in the US and Europe. TCS’ BFSI sector grew 1.3 per cent, sequentially in Q1; in the March quarter, growth was 3.1 per cent. The company, although, clocked a fair 10.6 per cent year-on-year revenue growth in Q1 in constant currency (CC) terms, supported by other sectors.

Although Infosys’ BFSI and overall revenue growth was relatively strong in Q1 and it upped its FY20 revenue growth guidance a bit from 7.5 per cent–9.5 per cent to 8.5 per cent–10 per cent, the company indicated softness in some pockets of banking and capital markets in the US and Europe.

“Client-specific benefits helped Infosys’ growth in Q1. However, demand-related concerns exist for the overall IT sector,” says Aniket Pande, analyst at Prabhudas Lilladher. Infosys’ American Depositary Receipts surged 6 per cent on Friday, but it needs to be seen if it sustains.

Factors such as the US-China trade war and Brexit-related issues are making IT spending tougher, mainly in the BFSI sector in the US and Europe. Given the higher share of BFSI sector and these geographies in revenues of domestic IT players, the degree of a potential impact can be gauged. 

Sector-wise, the BFSI sector contributes about 20 to 30 per cent to revenue share of most major players; in terms of geography, Europe and the US together account for 80-85 per cent the revenue pie of many Indian IT players. Other segments like telecom and retail are also seeing some demand pressure.

According to Antique Stock Broking, demand outlook is the most critical predictor of stock returns and price to earnings (valuation) multiple. Not surprisingly, the Nifty IT index has shed over 4 per cent in the last three months, versus a 0.8 per cent fall in S&P BSE Sensex and the Nifty50.

Another major challenge for the domestic IT sector is on the profitability front due to a tight cost structure. Higher subcontracting charges, talent supply constraints indicating potential higher employee costs, and unfavourable currency exchange rates are creating near-term margin pressure. The currency-led margin pressure is difficult to offset, says an analyst.

“It is likely to be a tough year for IT. Margin is directionally trending down, which is the biggest concern for IT players,” says Sanjeev Hota, head of research at Sharekhan. The two IT giants — TCS and Infosys — witnessed 90-94 basis point sequential contraction in Ebit (earnings before interest and tax) margin in Q1 of FY20. Despite positively surprising on revenue front, margin pressure and high attrition rate are restricting valuation premium of Infosys, as per IIFL.

The recent regulatory changes are further taking the sheen off IT stocks. Among major Budget announcements impacting sentiment include the imposition of 20 per cent tax on share buyback and increasing minimum public shareholding in listed companies to 35 per cent from 25 per cent currently. As per IIFL, minimum public holding may create an overhang on IT stocks in the medium term. TCS, Wipro and L&T Infotech have less than 35 per cent public shareholding.

Among a few positives, which could provide some support, is the rising margin-accretive and fast-growing digital business. Companies such as TCS, Infosys and Tech Mahindra have around 30-40 per cent revenues coming from the digital business.

Second, a muted performance by other sectors such as steel and automobile could make IT relatively comfortable for investors to hide during uncertain times. Thus, investors looking for exposure to IT stocks are recommended to be extremely selective. If demand and margins fail to recover, there could be further de-rating of IT stocks, says an analyst.