Potential for Indian IT sector stocks likely to see some rerating

Much of the bad news seems priced in, and a gradual recovery in US tech spending could happen from Q2

After disappointing guidances in the first quarter (Apr-Jun) of the 2023-24 financial year (Q1FY24) and valuation downgrades, the Indian IT sector could see some positive repricing as the bad news for IT maybe easing in Q2FY24.

A key negative factor was weaker demand from the US financial sector and from North America in general. The latest GDP (gross domestic product) estimates and sector-specific news suggest that the demand situation may not be quite so bad with a gradual recovery in tech spending in Q2. In addition, growth in the engineering and R&D outsourcing (ERD) segment could be stronger than in other services segment.

Large US banks spent more on tech (as a percentage of revenues) in Q2FY24 but at 6.6 per cent (versus 6.2 per cent in Q1FY24) this is much lower than peak levels of above 7 per cent in FY21. So there’s room for expansion here as macro-stability returns to the US. This would reverse a situation where Q1FY24 revenues were flat for IT companies.

Banks across the world see the need to improve digital infrastructure to make them more efficient and gain market share. At some stage, given that US bank revenues have grown in double-digits, smaller banks are likely to start investing in IT following the lead of larger banks.

From the IT services sector perspective, large-cap stocks look more attractive, for two reasons. One is that valuations for large IT companies are lower than mid-level and smaller IT firms. The other is that larger service providers could hold an edge when it comes to winning new business. It’s much too early to call a strong recovery but there’s relief that demand seems to have bottomed out and may be gradually recovering.

Indian ERD companies will benefit more than other services segments from the recovery. There are some long-term growth themes and a trend of higher external sourcing. ERD services require domain-specific, contextual knowledge of the client’s business and strategies and therefore have very high correlation to client industry cycles with low ‘maintenance’ component of revenues. So, ERD growth is strong during periods of client industry technology transitions.

Some of the growth will be captured by offshored GCCs (global capability centres) and while this generates employment, it doesn’t translate into revenues for listed Indian firms. But, a lot of ERD revenues will accrue to Indian IT outfits.

Areas of strong demand include digital engineering, and offshoring. Digital engineering will be leveraged across product lifecycles of design, production, maintenance and disposal. Technology transitions in manufacturing are also led by increased software induction and innovations in smart manufacturing.

Digital ERD spend may represent 59 per cent of global ERD spend by the 2026 calendar year or CY26 (up from 45 per cent in CY22). Sub-areas of interest will include “cloudification” across all segments, connectivity changes (driven by 5G penetration), convergences in IT-IOT processes, smart manufacturing, and massive transitions in transportation, including inductions of autonomous vehicles, electric vehicles, and also transitions across industries driven by sustainability concerns.

Apart from the software and internet sector itself, segments like automobiles, BFSI (banking, financial services and insurance), media, healthcare could be other areas of fast ERD growth. Quite a few ERD plays are relatively small/ mid-level stocks such as Cyient, Persistent Systems, Tata Elxsi, KPIT, etc.

Despite the gloomy advisories, the NSE IT Index is up 12 per cent in CY23 – and almost all of those gains have come since April 2023 – that is, in FY24. The IT index is up 19 per cent in the last 12 months. It has outperformed the Nifty50, which is up 10.5 per cent in the last year.