Tech Results – Technology stocks may be up against a rocky next few quarters

Business Today

The results of 2 of India’s biggest and most respected technology companies were announced last week. Apart from the rhetoric, the message is; that IT stocks are in for a tough few quarters as they grapple with a series of major headwinds.

Sales growth will be conditional

The guidance of technology stocks is for 15-20% top-line growth. That would be achieved as companies are increasingly adopting digital strategies to enhance their business. However, while business volumes are likely to increase, global headwinds like inflation and weak GDP growth mean limited pricing power for IT companies. Revenues will still grow but the ability of the top line to drive profits, as in the past, would be largely limited.

Watch for currency headwinds

One of the big challenges in the coming quarters will be the gap between rupee growth and constant currency growth. That is because large IT companies will be increasingly exposed to the risk of cross-currency headwinds. Today, most large IT companies have business models that earn a chunk of their global revenues from the Americas, UK and EU regions. With monetary divergence likely to be a reality with the ultra-hawkish stance of the US Fed, most of these IT companies are up against a lot of cross-currency risk. That is likely to become a major factor curbing constant currency growth for most IT companies.

Margin pressures to intensify

With the 2 largest IT companies have announced their results, the pressure on margins is evident. Both Infosys and TCS took a hit of 200-300 bps on EBITDA margins. This can be largely attributed to sharply higher manpower costs, higher operating costs and a spike in sub-contracting costs. The spike in labour attrition rates at 28% for Infosys and at above 17% for TCS are only adding to the manpower cost problem for these IT companies. There is one more risk. It is expected that with restrictions on travel removed, a lot of discretionary spending on global travel and visa charges will be back to haunt the books. This is going to be one big challenge for Indian IT.

How can investors approach IT?

Broadly, there are 3 rules to follow when investors select IT stocks in the light of Q4 results. Firstly, the positives are in the price but many of the risks may not be in the price still. Therefore, the upside potential on most large-cap IT stocks may be limited from current levels. Secondly, margin pressure is going to be a reality and that is not going away in a hurry. That would mean most IT stocks would see the gradual rationalization of valuations in the coming quarters. Thirdly, niche mid-cap and small-cap players in the IT space may have a lot more valuation headroom. Investors need to tweak their IT investment strategy and pick stocks accordingly!

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