Sustaining the premium price tag may be difficult for IT stocks

Ability to absorb cost pressure while maintaining growth would be crucial, say analysts

Pain in the IT sector was once again palpable when Cognizant Technology Solutions sharply cut its revenue and margin guidance for the calendar year (CY) 2019 on Thursday. Even some big Indian IT players have lowered their FY20 guidance. This suggests the financial performance of most IT players may be subdued in the coming quarters. In contrast, the current trailing 12-month price-to-earnings (P/E) valuation of the S&P BSE IT index at 21 times is still at a 9 per cent premium to its historical 5-year average. Thus, sustaining the valuation premium may be difficult for IT companies.

According to Amit Chandra, analyst at HDFC Securities, “Companies which can sustain their growth rates of the digital segment, protect their legacy revenue and maintain margins by absorbing the cost pressure will be getting higher valuation.”

The overall IT space has seen a good run in the last two years after a subdued show in 2016. After losing 8 per cent in CY2016, the BSE IT index has risen at a compounded annual growth rate of 18 per cent in the last two years ended December 2018. Factors such as cheap valuations due to the fall in 2016, improvement in financial performance and dismal show by some other sectors improved sentiment for IT stocks. But, things are turning back since the past two quarters due to macro-level challenges.

For instance, the March-2019 quarter (Q4) results recently announced by some IT players indicate that the sector is witnessing talent supply constraints. Employee costs are a key operating expense, accounting for over 50 per cent of the sector’s top line. Thus, even a small rise in staff cost (as a percentage of revenue) could hurt IT companies’ profitability or EBIT (earnings before interest and tax) margin and earnings.

Increase in wage rates and sub-contracting charges, as highlighted by IT players, are indicative of talent shortage. Even in Q4, EBIT margin of top players, those having declared results so far, contracted by 50-100 basis point  (bps) sequentially. For example, Infosys saw EBIT margins fall 113 bps sequentially. For FY20, too, Infosys has lowered margin guidance by 100 bps to 21-23 per cent.

“If companies fail to live up to the Street’s modest margin expectations, valuation could take a hit,” says Sanjeev Hota, head of research at Sharekhan.

While companies are taking steps, such as cost efficiency, focusing on more profitable offshore deals and digital business, to protect margins, it remains a  monitorable given the demand scenario. Apart from profitability, likely lower growth in topline is another spoiler for IT players. Though many companies believe demand is intact, they indicated weakness in business segments such as healthcare and geographies like Europe. Also, Cognizant’s concern over weakness in the financial and banking segment has added to the growth scepticism of the Street.

“Valuation of IT companies can moderate if concerns regarding a slowdown in the banking and financial services and insurance segment aggravate,” cautions Chandra.

Further, growth pressure could also come from dismal deal wins. Many mid and small IT companies (results declared so far) have either reported a fall or slower growth in deal wins. Top players (Tata Consultancy Services and Infosys) reporting strong deal wins, though, gives comfort.

“Deal wins/client budget is one major criterion for investors to gauge overall growth of companies. Companies with higher share and strong growth of digital deal wins should perform better,” says Vineeta Sharma, head of research at Narnolia Financial Advisors, who also believes there is little room for valuation upsides from current levels for the sector.

Moreover, client problems in some companies are aggravating the pain, some of which have got factored in valuation (like in case of Persistent Systems and Cyient).

Overall, market experts advise that investors remain selective while betting on IT stocks. While TCS is a top pick among large-caps, Zensar, Majesco, and L&T Infotech top the mid- and small-cap list.