The deceleration in demand for information technology (IT) services could continue for months, key leading indicators from the US suggest. Analysts at Nomura Financial Advisory and Securities (India) Pvt. Ltd point out in a 2 March note to clients: “US manufacturing PMI (Purchasing Managers Index) remains in contraction zone at 49.5 (compared with a near-term peak of 58), which implies that near-term IT stock performance and IT demand in the US could be impacted, as PMI is a leading indicator for both.”
Despite a sharp fall in PMI since end 2014, the Nifty IT index has outperformed the broader markets by about 7% during the same period. The drop in PMI is usually reflected in IT services demand with a lag of about two-three quarters. According to Nomura’s calculations, tier-1 IT services firms grew revenue by more than 13% in constant currency terms in the December 2014 quarter. Growth remained in the 13% range in the next two quarters. And, sure enough, growth rates started falling after a three-quarter lag (since the time PMI started to fall), and stood at 10.6% in the December 2015 quarter.
With PMI moving into the contraction zone (below 50) since October 2015, growth rates can be expected to fall further this year. Nomura’s analysts add that “the financial performance of key client industries (banking and financial services, insurance, retail, consumer, chemicals and hi-tech) has worsened over the past three to four quarters, with pharma and auto being the only saving grace”. Besides, private sector job additions in January this year were the weakest in the last five years.
If you thought that the depreciating rupee would provide some buffer for profits at a time of declining revenue growth, note that operating profit margins are near five-year lows.
All told, the IT services industry is far from being strongly placed enough to justify outperformance vis-a-vis the markets. Having said that, as is the case so often, there is a scarcity of decent alternatives, thanks to which the IT stocks continue to trade at healthy valuations.
