Tech investors are driving in a fog

But now, with the risk of a global recession looming large, it has become difficult for investors in IT stocks to gauge the demand scenario. “A key debate surrounding the 3Q growth outlook is how much of a seasonal slowdown is factored in,” said analysts at JM Financial Institutional Securities Ltd. There could be an additional 1.5-2.5% impact, it said.

In addition, increased cost caution among customers amid macro uncertainties may constrain the pace of revenue growth of the sector and increase pain for IT investors. Worryingly, the momentum seen in short-cycle deals could slow as customers delay their discretionary spending. Remember, IT giant Accenture in its recent results has already hinted about the growing focus of customers on cost optimization. Against this backdrop, investors should be closely watching the trajectory of the big deals and bill-to-book ratio in third-quarter earnings.

In addition, clarity on growth on the demand outlook is not expected in the third quarter management comments as budgeting from customers may still be ongoing. This uncertainty does not bode well for the revenue visibility trajectory and overall investor sentiment. Among Tier-1 IT service providers, Infosys Ltd and HCL Technologies Ltd are expected to maintain their FY23 constant currency revenue growth guidance. That said, meeting the top end of the guided range will be a tall task.

Investec Capital Services (India) has said in a report that the second half of FY2023 continues to be at risk for stocks, followed by a sluggish start to FY2024. Due to this, Tier-1 growth estimates can be reduced from 8% to 6-7%. However, tier-2 firms may see a sharp decline in their revenues. That said, margins are set to see a sequential improvement in Q3FY23. This will be aided by better utilization, freshers being billable and favorable cross-currency movement for some companies. While the supply-side pressure is easing, its benefits are likely to be reflected in margins with a lag of one to two quarters.

Jefferies India Pvt Ltd said that on an overall basis, the sector’s Ebit margin is estimated to recover 50 basis points sequentially in 3QFY23, driven primarily by HCL, TCS Ltd and Coforge Ltd. Ltd

Meanwhile, segment-wise, in the Q2FY23 commentary, IT companies highlighted weakness in certain sectors such as mortgage, retail and hi-tech. It remains to be seen whether more verticals are feeling the aftershocks of a potential global recession. Geographically, the outlook for Europe is bright given the energy shortages and inflation that the region is facing. Trends in hiring, attrition and wage hikes are also important.

In Calendar Year 22, the Nifty IT index underperformed with a correction of 26%. Even though the benchmark index Nifty 50 delivered a modest 4% return in Calendar Year 22, the Nifty IT index lagged behind by a mile. Valuations of IT stocks have cooled from the recent peak, but given the above challenges, they are still expensive.

Ambit Capital Pvt Ltd said the Tier-1/Tier-2 IT price-to-earnings valuation at 22.9x/24.8x is still at about 28/50% premium to the pre-Covid three-year average. Ltd. in a report on January 3.