Cheap valuations will prevent IT stocks from bigger fall

Less than a month back Royal Bank of Scotland scrapped a project to set up a separate bank in the United Kingdom for which Infosys was the technology provider, signalling the first impact of Britain’s exit (Brexit) from the euro zone.

Analysts immediately started pricing in the impact of Brexit in their models and indicated that not only Britain but the entire euro zone might be impacted by slower order flows.

Now, the slackness in decision making seems to have crossed the Atlantic. India’s largest IT player TCS issued a warning, saying there could be sequential loss of momentum in the US as many clients were holding back on discretionary spending in the banking, financial services and insurance (BFSI) segment in the US.

 

Naturally, IT stocks across the board fell as not only two of the major markets for Indian IT industry are feeling the heat but also the main revenue driver BFSI space, is under pressure. Post-market hours on September 7, 2016, TCS said it intended to update investors on business trends in Q2 September 2016.

Based on data at the end of August 2016, the company has characterised customer outlook as one marked by abundant caution, with some holding back of discretionary spending - particularly in the banking and financial services (BFSI) vertical in the United States - resulting in a sequential loss of momentum. TCS had already posted a muted first quarter with BFSI space posting a growth of only 1.7%.

To make matters worse for TCS, reports say that its chief marketing officer (CMO) John Lenzen has quit. Lenzen, based out of Chicago, was a member of the Tata Group Brand Advisory Council.

Along with the larger players, even smaller ones are feeling the pressure of slow order flow. Mindtree recently said it expected the second quarter revenue to be lower than the previous quarter on account of project cancellations, slower ramp-ups in few large clients and impact of cross-currency movements.

Statements by IT majors suggest a structural slowdown, which is being discounted by the market. But how long will this indecisiveness lasts in these two continents is key to the future growth.

Euro zone slowdown is mainly related to Brexit and the uncertainties surrounding it. Till negotiations between Britain and its main trading partners are clear, spending in the European continent, especially in the BFSI space, is now expected to be slow. 

As for the US, a lot depends on interest rate scenario in the country. In an interview with CNBC, Ravi Menon of Elara Capital pointed out that most banks when they started this year would have factored in rate increase by the Fed mid-year and would have allocated budget factoring that in. But interest rate hike has been differed by the Fed citing Brexit-related uncertainties and lack of inflation in the economy. Menon said that net income of banks in the US would be under pressure and that might have led to more budget cuts.

While the prospects for IT sector looks bleak in the short to medium term, share prices of most the companies seem to have priced in the slowdown. TCS’s announcement was a shocker for the company as many analysts were overweight on the stock as compared to its peers. The stock has thus reacted with a fall of nearly 6 per cent as compared to a smaller reaction from other players in the industry.

Broking form Ambit in its note on TCS has pointed out that the demand environment has clearly worsened in the past two months. However, this is a temporary issue and factored into current valuations where the stock is trading at 17 times its FY18 earnings. Apart from Infosys (trailing PE of 17) most of the smaller players are trading at lower teen valuations.

It is the relatively cheap valuation of the IT sector as compared to the overall market which offers some cushion to the fall. Funds are underweight the IT sector and any fall will probably see them buying the market leaders at a cheaper valuation as fund managers are strugglling to find good investment bets at the current valuation. More than price correction, time correction will play out in the IT space as the market waits for growth to pick up.