IT sector: Challenges remain, but not a bad bet for investors

On Thursday, India’s tech blue chip Infosys reported a 13.4 per cent rise in its consolidated net profit for the quarter ending December 2022. Earlier this week, the largest IT company of the country, Tata Consultancy Services Ltd (TCS), posted a 11.02 per cent growth in profit for the quarter. Tech companies, thus, appear to be withstanding the vagaries of the economic slowdown, which has been triggered by high inflation, high interest rates, and falling growth rates across the globe.

What is going right for the tech sector?

Infosys’s operating margins in the third quarter remained resilient due to the cost optimisation benefits that have offset the impact of seasonal weakness in operating parameters. Attrition also reduced meaningfully during this quarter and is expected to decline further in the near term, which is a positive development for the company.

“We feel that the performance of the company (Infosys) would continue to remain resilient due to strong traction in its digital segment and continued focus on operational efficiencies,” said Manish Chowdhury, Head of Research at Stoxbox.

While the global economy was hit by high inflation and interest rates, tech companies maintained their growth tempo in overseas markets too. Among major markets, North America and UK led with 15.4 per cent growth, while Continental Europe grew 9.7 per cent. In emerging markets, Latin America grew 14.6 per cent, India grew 9.1 per cent, Asia Pacific grew 9.5 per cent and Middle East & Africa grew 8.6 per cent, according to TCS.

“Our revenue growth was strong in the quarter, with both digital business and core services growing. This is a clear reflection of our deep client relevance, industry-leading digital, cloud, and automation capabilities, and the unrelenting dedication of our employees,” said Salil Parekh, chief executive officer and managing director, Infosys.

What is the outlook for the IT sector?

Globally, experts anticipate greater uncertainty in consumer technology as Covid-19 tailwinds continue to abate, energy prices rise in Europe and global economic activity slows. “We believe areas such as consumer IT hardware, gaming, e-commerce, and digital advertising may have a slightly longer road to recovery. We also expect consumer discretionary spending to weaken as unemployment rises and as excess household savings that had built up during the pandemic decline amid persistently high inflation,” said Jonathan Curtis, Portfolio Manager, Franklin Equity Group.

In fact, this began to play out during the second half of 2022, which led to negative estimate revisions across the semiconductor, consumer personal computer (PC), gaming, and internet industries.

Fitch Ratings said Indian IT sector outlook for 2023 is stable. “We expect Indian IT services companies’ revenue growth to slightly exceed global competitors’ in 2023 and 2024, as customers will most likely prefer lower-cost IT vendors amid an economic downturn. In the global financial crisis of 2007-2010, Indian IT companies’ US dollar-denominated revenue expanded at a CAGR of 16 per cent – outperforming global peers such as Accenture plc, Capgemini SE and Atos SE, which all reported flat to declining revenue,” Fitch said.

What is likely to hurt the IT sector?

Two factors that are likely to cast a shadow over the sector are high inflation and sharp increase in interest rates over the last four quarters. This has forced companies to reduce their IT budgets amid talks of recession. While high inflation and rising interest rates are increasing the cost of capital for companies, they are also eating into disposable incomes of individuals and forcing them to reduce their spending amid a weak macroeconomic outlook.

This is directly impacting the outlook for technology companies — whether it is with regard to their products, services or with regard to ad revenues — and is thereby impacting their share prices. As for Indian IT majors, an adverse macroeconomic situation in the US and Europe will keep the order flows, business growth, revenue and share prices dampened.

How are tech firms faring on stock markets?

“The valuation still looks attractive compared to historical averages and we believe that there are limited downside risks going forward,” said an analyst with a broking firm.

The stock market performance also clearly reflects the concerns that the markets have regarding IT companies, over slowdown concerns in the US and Europe and its impact on Indian IT firms. In the period between April 1, 2022 and January 12, 2023, while the benchmark Sensex at BSE has risen 1.14 per cent, the IT index at BSE is down 21.28 per cent. Leading IT companies TCS (-18 per cent), Infosys (-24 per cent) and HCL Technologies (-21 per cent) are already down from their 52-week high levels.

In fact, there has been a sharp decline in holdings of IT companies by mutual fund and foreign portfolio investors. However, IT companies like TCS and Infosys have also announced buybacks at good prices for the shareholders.

IT and technology companies witnessed a sharp surge in valuations during Covid times as everything was turning digital and there was optimism around their growth. Amid growing concerns on economic slowdown, even shares of top US tech companies are yet to reach that high again.

If the US tech giants are struggling, it is unlikely that the Indian IT sector, which is largely dependent upon business and revenue from the US and other developing economies, will go unscathed.

Experts, however, feel that as prices of IT companies have witnessed correction on account of growth concerns in the US and Europe, the softening in inflation and stability in interest rates will result in upwards revision in share prices of these companies. “So, it would not be a bad idea to invest in them on dips in leading IT majors, for medium to long term,” said a fund manager with a leading mutual fund.

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