Stay selective but not away from the IT sector in 2023: IIFL Capital Services

3 Jan 2023 , 12:00 PM

Analysts at IIFL Capital Services see 2023 to be a tale of two halves, where a cyclical blip in H1 will be followed by secular recovery in H2, resulting in sector growth being firmly above pre-COVID levels over FY24-25. Supply-side pressures will ease off considerably leading to margin expansion, further supported by INR depreciation. Hence, the sector should still deliver low-teens earnings growth in FY24. 

Valuations are at above 10-year averages, but may sustain, given sector’s structural growth trajectory should remain above pre-COVID levels in the medium term. Analysts at IIFL Capital Services recommend being selective in stock picking with bias towards leaders with diversified portfolios, rather than companies with concentrated revenues. 

Their top picks are Infosys and TCS among large caps; and Persistent Systems, LTIMindtree and Cyient among the mid-caps. Companies with skewed revenues towards a particular vertical or service line, can be avoided for now. Analysts at IIFL Capital Services have downgraded Tech Mahindra and L&T Technology Services to Add; and have maintained Reduce on Wipro.

 

IT spending – delayed but not denied

After two years of accelerated growth post COVID, we are witnessing moderation in demand; due to rising macro pressures. The nature and size of deals are changing from front-end transformation to cost take outs and efficiency-led deals. While we may see some delays in IT spending in near term, analysts at IIFL Capital Services believe Indian IT is likely to continue being a beneficiary of the multi-year digital transformation journey. They forecast the sector to grow at 10% USD constant currency revenue CAGR over FY23-25 vs pre-COVID 5/10-year average at 8%/9% respectively, despite the recent slowdown. 

The great resignation is behind

With normalizing demand, supply side pressures have started to ease. High fresher intake and re-skilling are resulting in improved talent fulfilment, while attrition/inflation may ease off through 2023. Indian IT hired 328k people in FY22 versus avg. 74k in the five years preceding that. Offshore hiring was stretched on 10ppt shift, in an effort to offshore during the pandemic. Onsite cost pool has inflated due to multi-decadal high inflation. While these factors may cool off slowly, slower demand should ensure reduced hiring pressures.

Upward margin bias to propel earnings growth

The sector has faced ~250 basis points margin compression since FY21, on rising supply pressures and reversal of pandemic-led savings — which may have now bottomed out. In 2023, analysts at IIFL Capital Services expect lower hiring pressures, rationalization of sub-contracting costs, forex tailwinds and pyramid restructuring to aid steady margin expansion. Hence, they forecast 14% PAT CAGR over FY23-25 for the sector, coupled with robust capital allocation.

It is not about large versus mid-caps

Nifty IT index multiple has contracted by 32% through CY22 and is now trading at 21X— slightly above the 10-year average of 18.6X. Analysts at IIFL Capital Services believe these levels are sustainable, as they expect medium-term growth to remain above the decadal average. Therefore, while further rerating is predicated on a sooner-than-expected recovery in IT demand— which could play out in H2— risks of derating will depend on recession’s depth in developed markets. In that context, analysts at IIFL Capital Services recommend staying with leaders with balanced portfolios across caps.