Downturn in IT stocks just a passing phase

In April, the stocks of India’s leading information technology companies took a beating in relation to the rest of the market. As this has come after the sector leading the market through the Covid-19 pandemic, it is necessary to determine why this should be happening.

Advertisement

This can be for one of two reasons. First, after a long period of buoyancy, the stocks may be finding a sustainable level. After all, sectoral valuations cannot be beating the market indefinitely. Second, and this is more important, it is necessary to determine if the immediate prospects for the industry have turned negative.

The combined market value of the big five IT companies (TCS, Infosys, Wipro, HCL Technologies and Tech Mahindra) has come down by as much as 10 per cent during April, compared to the overall index going down by only 1.3 per cent. The decline looks more vivid if we compare the latest valuation to what has been the historical peak. The valuation in April almost touched Rs 27 lakh crore compared to a valuation of Rs 31 lakh crore in end December, a 13 per cent fall.

The results of the top IT company TCS for the quarter ended March have in fact been positive. Consolidate net profit was up 7.4 per cent compared to a year ago. This was driven by a nearly 16 per cent rise in revenue compared to a year ago. This is in line with the revenue for the full financial year 2022 going up by nearly 17 per cent.

The management finds TCS closing the year on a strong note. An all-time high order book provides a strong foundation for continued growth. Thus the prospects for the firm are anything but negative.

Infosys, the second largest IT firm, did even better in the last quarter. Its net profit rose 12 per cent compared to a year ago. Revenue rose at a much higher rate of 22.7 per cent. As for the year ahead, it expects revenue to grow at 13-15 per cent in constant currency terms, that is assuming the rupee-

dollar rate remains unchanged.

The management drew attention to the fact that it achieved the highest annual growth in a decade. It continued to gain market share and saw immense potential ahead. As IT continues to face high attrition and visa restrictions in the US, Infosys indicated that it would hire talent globally, particularly with an eye on strengthening its digital capabilities.

If this is how the leaders have done and expect to do, then why has April seen a downturn in valuations? This is because valuations were already very high and the fourth quarter results turned out to be good but not as good as expectations. Valuations expressed by price-to-earnings multiples were at a record high before the fourth quarter.

It seems that the sell-off trigger was the fourth quarter earnings being lower than expectations due to a decline in margins. Analysts also anticipate that profit margins will be growing at a slower pace in the year ahead.

Here we need to go back to the overriding reality that has been stalking IT firms for some time now. They were able to manage exceptional growth through the pandemic because they could successfully help their clients respond to the technological challenges which faced them.

Clients needed to enable their staff to work from home as far as possible during the pandemic. This required a change in the firms’ IT infrastructure, both hardware and software. Plus there was a move across the world for firms to move their IT assets to the cloud. Operating systems, applications and data all had to be migrated to the cloud.

Fortunately for Indian IT companies, they were able to hold the hands of their clients through this entire process. This made it critical for IT companies to augment their own skills to be able to meet the new and emerging needs of their clients.

Thus during the Covid-19 period, there was a big rise in the demand among IT companies for more high-end technical skills. Till now, IT companies’ rank and file mostly wrote software codes and managed the IT infrastructure of their customers.

As a result of all this, IT companies in order to satisfy their hunger for skilled hands, had to offer better packages and the whole industry was engaged in a game of poaching on their competitors. As this process continued, IT companies found themselves saddled with rapidly rising compensation bills for their staff.

This rise in costs created a hiatus between the rate of growth of revenue on the one hand and margins on the other. IT companies were able to get lots of new business which assured them good revenue growth but by having to pay more for staff in a service sector where staff costs are the most important, their profit margin growth fell behind their revenue growth.

How long will this continue and which way do analysts expect the sector to go? According to one analyst, the falling behind in share prices is temporary and IT companies will regain their pace as they go along. With volumes growing handsomely and bulging order book, revenue growth is assured. Then his optimism seems to get the better of his logic and he foresees that there will be good earnings growth despite margin pressure.

There is also an expectation that the continuing depreciation of the rupee against the US dollar will give a boost to rupee earnings but there is a catch in this. Because of visa restrictions, IT companies are going ahead with robust near shore (near the client location) hiring. This will raise overseas costs and commensurately converted rupee costs.

The biggest long-term asset of the IT companies is the quality of their leadership, their ability to respond to challenges and innovate. They are spending more on training and as this happens across companies, there will be a rise in industry skill levels. This will go a long way in addressing the skills shortage, poaching and rapidly rising wage bill. In sum, despite the recent share price setback, the long-term future of India’s IT leaders continues to be bright and the country can depend on their leadership to ensure that.