Tech sector is on cruise control, but keep an eye out for signals
For IT firms, the covid-led trend of working-from-home (WFH) came as a blessing in disguise. The increased thrust on digital transformation and cloud adoption aided an impressive earnings growth, fuelling a sharp rally in IT stocks. Little wonder then that the Nifty IT index has been one of the best performing sectoral indices in the past year. With returns of around 90%, it has comfortably beaten the Nifty50 index, which has risen 52% in the same span.
With a significant jump in the sector’s market capitalization, its weightage in the Nifty50 index, which has been on the rise, has touched a multi-year high of 18%, showed data compiled by Motilal Oswal Financial Services Ltd. This optimism also has rubbed off on valuations. The one-year forward price-to-earnings multiple of this sector is at 30 times, the highest in the last 15 years, said the Motilal Oswal in a report on 7 September.
“The multi-year high weightage of the IT index and peak valuations are both tied to the robust earnings growth of technology companies and their resilience during the pandemic. At the peak of the pandemic impact last year, IT companies saw year-on-year (y-o-y) Ebit growth when companies in other sectors were severely impacted," said Kumar Rakesh, senior auto and IT analyst at BNP Paribas India. Ebit is short for earnings before interest and tax.
In Q1FY22, key IT services firms saw strong dollar revenue growth on a sequential basis, aided by broad-based growth across geographies and services. Further, the management commentaries point to a robust tech spending environment. As far as deal wins are concerned, analysts say, the median book-to-bill improved from 1.2 times in Q1FY21 to 1.3 times in Q1FY22 and provides strong growth visibility for FY22.
Rakesh further added that the IT sector has been a beneficiary of the WFH culture, leading to greater digital transformation among clients and that in turn has kicked off a multi-year growth cycle for the sector. Therefore, in case there’s another wave, the IT sector is likely to be less impacted, he adds.
That said, the sector is not completely immune to some other downside risks. One of them is margin compression due to increased supply-side pressure on high-demand talent. In the June quarter, operating margins fell by 80-200 basis points sequentially for many IT firms, mainly hit by wage hikes and employee additions. One basis point is one-hundredth of a percentage point. On a y-o-y basis, margins are higher due to lower travel expenses, but with normalcy resuming discretionary expenses would come back.
Secondly, investors would also be closely watching the composition of future deal wins. There is a risk of the deal-win pipeline being skewed with a handful of sectors driving the momentum, including the banking and financial services (BFS) and healthcare industries. In the June quarter, Indian IT firms reported strong sequential growth in the BFS vertical. For Infosys, nine large deals out of 22 were in financial services in 1QFY22. L&T Infotech and Mphasis reported strong sequential growth of 9.9% and 8.4%, respectively, in the BFS vertical in the latest quarter.
Nonetheless, expectations of strong demand momentum sustaining would keep the sector’s valuations at an elevated level. “Commentary on growth is largely status quo, while supply pressures remain high. Valuations already build 11-15% USD revenue CAGR for tier-1 and 15-22.5% for tier-2 over FY21-31," analysts at Ambit Capital Pvt. Ltd said in their recent report. CAGR is short for compounded annual growth rate.