Although the slowdown in global IT spending is expected to continue, only large IT services players are equipped to win billion-dollar deals
The Nifty IT index has been soaring over the past three trading sessions. It gained 1 percent on February 14, about 1.13 percent on February 15 and 1.71 percent on February 16, with all stocks fuelling the benchmark index higher.
The S&P BSE IT Index has also rallied in tandem, gaining over 3 percent in the past three sessions.
Tech Mahindra and Tata Consultancy Services have been the top gainers among the large-caps, while stock-specific developments propelled the share prices of smaller companies Nucleus Software and Tanla Platforms higher.
A set of in-line quarterly results, moderate deal wins, and ‘buy on dips’ seem to be aiding the sector, analysts said. The Nifty IT index, which was among the worst sectoral performers in 2022, is up over 7 percent for the year, while the benchmark Nifty 50 is down 1 percent.
“A recession view for the developed markets, which was a consensus a few months ago, still holds but with reduced intensity,” Kotak Securities said in a recent report.
Majority of IT companies’ revenue is derived from the Americas, and retail sector is the largest business segment for these players followed by financial services. “The US retail sales data print this week showed a stark recovery which has supported the IT stocks, and additionally, interest rates seem to be nearing their peak with most of the hikes behind us,” Sreeram Ramdas, vice president at Green Portfolio, said.
Billion dollar deals
Though fears of recession in the US and Europe and reduced client spending continue linger, several large-cap IT companies signed billion-dollar deals in Q3.
According to Bernstein Research, “There is now a divergence of execution between large-caps and mid-caps as large deals intensity has started picking up with clients focusing on vendor consolidation.”
Vendor consolidation means reducing the number of external suppliers to a handful of trusted partners.
In Q3, Wipro signed 11 large deals with a total contract value of over $1 billion. Infosys signed 32 large deals worth $3.3 billion last quarter, the highest in eight quarters. The total contract value for TCS was steady at $7.8 billion.
The Tata group IT firm recently announced a £600-million contract with the UK-based Phoenix Group, which was the largest for TCS in this financial year and its largest in the UK after three years.
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Margin recovery
Most IT companies reported sequential improvement in margins in Q3.
According to Moody’s, improving employee utilisation from hiring in prior years and steadily declining attrition will likely arrest further margin pressure.
For stocks under Jefferies’ coverage, aggregate margins recovered by 50 basis points quarter-on-quarter to 20.6 percent. Midsized firms fared worse, with their aggregate margins down 130 basis points QoQ against a 70 basis point expansion by large-sized IT firms.
One basis point is one-hundredth of a percentage point.
Large-caps remain favourites
The Street anticipates the slowdown in global IT spending at about 3-4 percent against 6 percent and 8 percent in 2022 and 2021, respectively. In this backdrop, large-cap IT companies will emerge as winners as there is an “extraordinarily high barrier to sign large deals,” Bernstein said.
“Only six-eight players can compete and win. The ability to structure large billion-dollar deals requires deep understanding of the new technology stack, strengths in integrated service lines, which only large IT services players can provide,” the firm said.
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Infosys remains the top pick for analysts and brokerage houses, given its superior revenue growth. Moody’s expects 13 percent revenue growth for Infosys compared to 8 percent revenue growth for TCS in FY23. Moreover, Infosys surprised investors by raising its revenue growth guidance during the Q3 results announcement.
For Jefferies, Infosys is the only pick in the sector. Bernstein analysts have ‘outperform’ ratings on TCS and Tech Mahindra too. They like TCS for its billion-dollar deal playbook and Tech Mahindra for its reasonable valuation. They have ‘market-perform’ ratings for Wipro and HCL Technologies.
Word of caution
The Nifty IT is trading at an above-average premium of 25 percent to the Nifty and valuations remain rich, Jefferies said. It has a cautious stance on the sector.
Kotak Securities said a deep recession is not fully priced in.
“The stocks are at an interesting juncture—moderate upside if it is just a slowdown in developed economies, moderate downside in case of a recession,” it said in a recent report.
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