Better margins may not be enough to revive IT stocks

Sector bellwether Tata Consultancy Services Ltd’s (TCS) Ebit margin rose by 50 basis points (bps) sequentially in Q3 to 24.5%. TCS is confident of achieving an Ebit of 25% by Q4FY23. One basis point is 0.01%. Margin of close competitor Infosys was flat at 21.5%. The company has retained its FY23 margin guidance at 21-22% and expects it to be around the lower end of the band. According to Investec Capital Services (India) Ltd, in line with historical trends, Infosys’ margin could potentially decline in Q4. However, there is room to improve margins through FY24/FY25 led by better utilization, potentially lower wage increases in FY24 with lower attrition and lower subcontracting costs. “Overall, we estimate Ebit margins improving by 40/50bps in FY24/FY25E,” said the Investec report.

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HCL Technologies’ margin rose by 170bps sequentially to 19.6% aided by the robust performance of its software segment. The management has lowered the upper end of its FY23 margin guidance by 50bps to 18-18.5%. Jefferies India expects HCL’s margin to be in the 18-19% range over FY23-25.

Wipro Ltd saw its IT services margin increase to 16.3%, exceeding consensus estimates. This surprising margin beat was despite salary hikes and promotions and was mainly aided by pyramid rationalization and automation. Wipro’s management believes that the Q3 margin will be the new base, hereon.

“Commentary by tier-1 IT managements was mixed on the demand front and points to some near-term caution and delay in client decision making, so investors can seek solace from the fact that at least margins have started to improve, especially as supply-side pressures are receding,” said an analyst at a broking firm, requesting anonymity.

A combination of positive factors led to margin expansion for tier-1 IT companies. These include better operational efficiencies, freshers becoming billable and favourable cross currency movement. Also, with multiple levers in place such as lower attrition, the margin outlook for tier-1 companies is likely to improve.

Considering that Q3 is a seasonally weak quarter for the sector, the sequential constant currency revenue growth was not as bad as earlier anticipated. That said, the lack of revenue visibility for FY24 remains. Also, companies have indicated weakness in segments such as mortgage, retail and hi-tech.

Indeed, an improving margin outlook is a bright spot amid fears of recession and demand slowdown. However, for now, that is not enough to trigger a revival in the performance of IT shares. In CY22, shares of tier-1 IT companies gave dismal returns with the sector index Nifty IT falling 26%.

“A turnaround in tier-1 IT stocks will happen gradually and depends on how the FY24 revenue outlook shapes up. Expectation is that a shallow recession will hit the industry and that could last for a couple of quarters,” said Omkar Tanksale, senior research analyst, Axis Securities Ltd. He said while it is difficult to predict when this could occur, in the near-term, IT stocks won’t see a sharp up move.

Of course, valuations of tier-1 IT firms have corrected from their recent peaks. But given the uncertainty, the lower valuations hardly offer much respite.