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Entire IT sector staring at slowdown but these two stocks may weather the storm

Amid a fast-changing macroeconomic environment, hawkish central banks across the globe, and rising inflation, cautious companies are likely to cut tech spending, said analysts at Nomura in a note.

Nifty IT
The Nifty IT index is down 7.24% so far this year. (Image: REUTERS)

Amid a fast-changing macroeconomic environment, hawkish central banks across the globe, and rising inflation, cautious companies are likely to cut tech spending, said analysts at Nomura in a note. The brokerage firm has downgraded a large number of IT companies under its coverage, but it sees only two firms doing well — Tech Mahindra and Infosys. “We think enterprises’ willingness to spend on digital transformation will continue, but growth rates on spends are likely to decelerate constrained by revenue and earnings volatility,” it said. 

Correlation between earnings growth and tech spending

The Nifty IT index is down 7.24% so far this year. The financial performance of companies across the globe is expected to slowdown going ahead as costs rise. “We see a strong correlation between financial performance of the sample set and IT services revenue with a lag of 1-3 quarters (depending on the sector), indicating a potential slowdown for IT services demand in FY24,” the report said. Nomura studies revenue and earnings profiles of close to 750 listed companies across the globe and found there could be a material slowdown in the overall financial performance in the upcoming quarters.

Inflationary pressure, however, is also expected to intensify the need to outsource. Outsourcing by companies will, to some extent, offset the potential hit on discretionary tech spending by the global enterprises in the wake of a weakening and uncertain macro-economic environment. 

Margin relief on cards

Nomura analysts noted that easing supply-side issues, improved pricing, and a weakening currency may provide some margin relief for IT companies. “We think currency deprecation could be a big wild card in the margin forecast for the sector. While we are building in a USD/INR exchange rate of 77 for FY23F and 78 for FY24F, a sharper depreciation of INR could be a significant tailwind given that every 1% in depreciation yields ~25bp in EBIT margin improvement,” they said. Attrition is also expected to fall going ahead. 

Infosys, Tech Mahindra only bullish calls

Analysts have lowered their FY23-24F EPS by 0-5% for their coverage universe, mainly driven by slowing revenue growth. “In our pessimistic scenario (growth reverting to pre-COVID level) and assuming no margin improvement in FY24F, we see ~16% downside in large caps from current levels,” Nomura said. The brokerage firm has downgraded TCS and L&T Infotech from Neutral to Reduce based on valuations and further Wipro, HCL Technologies, and Persistent from Buy to Neutral, based on the same parameter. Target prices have also been cut by 16-38% by Nomura.

The only survivors among the expected carnage in the IT space are Infosys and Tech Mahindra who still retain a ‘Buy’ rating. However, target prices for both of these have also been scaled down.

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