The mood around the Indian IT industry seems to have changed dramatically in the recent quarters. While, it started of with excitement and talks about how robust the growth is as we were coming out of pandemic, the tone seemingly has taken a turn for the worse. And the stocks prices have been reflecting the same.
Mean reversion in hiring activity
I still remember vividly, the 2 to 4x kind of salary jumps that employees saw post pandemic in the IT industry. Attrition rates soared to record levels, record ESOPs and big salaries hikes became a norm. Fast forward to today, the pressures of recession in US, high inflation has started to catch up with the Indian IT companies. While, we have not seen mass layoffs right now, hiring surely has taken a hit in the last few months in the Indian IT space. Things might just get a little worse before they get any better as far as the hiring setup is concerned.
Mean reversion in business growth
The Indian IT service business model works very well with revenues in dollars and costs in rupees, making them one of the lowest cost service providers for the global companies and offering us as investors - a rupee-dollar hedge. While there continues to be long-term structural tailwinds, the sector is expected to go through a slowdown phase in the near term. Revenue growth should revert back to low to mid-single digits for the Tier-1 companies like TCS and Infosys. Two key drivers leading to this are (A) the weak global macro environment and (B) concerns on the overall BFSI space globally. BFSI contributes 30-40% of revenues on average for most Indian IT companies. I would be more worried about Tier-2 IT companies which have a heavily concentrated client base, especially if they are from BFSI industry.
The common theme coming out from the management commentary as well is that clients are delaying new projects, cutting down on discretionary projects while the focus continues to be on cost optimization and vendor consolidation-related spends.
Indian IT Services industry grew by 7% CAGR over FY15 to FY20 (in dollar terms). During FY20-FY23, we saw a surge in global IT spends and the industry grew at ~9% CAGR (dollar terms) over FY20-FY23 period. I expect growth to normalize in the coming years and multiples to de-rate as a result. This is why, despite the sharp correction that we have already seen, I feel there this year might throw up better entry points to invest as far as IT sector is concerned.
Mean reversion in valuation and sentiments
The Nifty IT index is prominently made up of large cap IT service companies. In terms of my valuation setup, the first overvaluation signal on Nifty IT index came as early as October 2020 and has remain elevated up until last year’s correction. The index is at much more reasonable valuations now but still is not a clear buy yet.
In terms of market sentiments, I would describe it as cautious optimism. There seems to an agreement that IT sector will continue to do well over long term and might just see some near-term challenges. But in general, there still seems to be enough optimism baked in the stock prices. Overall, would like to wait and watch and perhaps enter on further dips from hereon.
ER&D Space (Engineering, Research & Design Services)
The ER&D space in India has grown from strength to strength in India. It is a difficult business to scale up. This is generally a long gestation period of building capabilities and performance durability in the market before large order wins starting flowing in. This is a higher margin business and stronger moats once business starts scaling up well as compared to traditional IT Service industry. India’s ER&D Industry looks ripe to grow in mid double digits over the next decade. This is one space where one needs to keep a close watch on.
In terms of valuations, they have run up well ahead of fundamentals and could see elongated time correction phase. A lot of these names have been listed in the last few years so there is not enough data yet. However, valuations still look expensive and I would avoid taking fresh positions in this space currently. Any miss on street expectations in the quarterly earning numbers and we could see sharp corrections in these counters.
Closing thoughts
The underlying premise seems to be that the overall IT sector is emerging out of the pandemic era on a stronger footing because of their business model and the way IT spends in general have increased. There could be some near-term pain given the business uncertainty at the macro level. Valuations are still not cheap to buy IT in bulk and there might be a few knee jerk reactions to earnings miss like we saw in case of Infosys last week. Having said this, I would keep an eye out for good buying opportunities over the rest of the year.
Hope you found this helpful. Look forward to hearing your thoughts and opinions.
Best,
Shivam Jain
Disclosure: I’m not a SEBI Registered Investment Advisor. All content on this website is purely for educational purpose. Please consult your financial advisor before making any investment decision.
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