After nearly a decade of making profits from the IT sector, investors are disappointed after second quarter results as most of the prominent IT companies’ results either matched or fell below market expectations. In the second quarter of FY24, Tech Mahindra recorded a significant decline in profits year on year. This was highest yearly fall in profits in over a decade. In contrast, Infosys and HCL Tech announced cuts in their revenue growth guidance.
Although the major IT companies have disappointed, most mid-cap IT companies have consistently achieved good growth in profits year on year basis. Unlike the giants, Coforge maintained its revenue growth guidance, while KPIT Tech increased its CC revenue growth guidance from 27-30% to 37% plus. The outlook for operational profit growth also increased from the previous 19-20% to over 20%. However, the challenge is that the majority of mid-cap IT companies are trading at a PE multiple above 42. PE, or Price-to-Earnings multiple, tells us about the valuation of shares through earnings multiples.
Additionally, small IT companies such as Intellect Design and Zensar Tech, have seen growth in profits ranging from 54% to 205% year on year, even in a challenging environment, thanks to their robust order books. Interestingly, most small IT companies are doing business at a PE multiple valuation below 39 times. Now the question is, what is the outlook for this sector? What can we expect in the coming quarters?
Experts believe that economic uncertainty in the United States and Europe, along with rising interest rates, does not paint a very positive outlook for the short term in this sector. If the Israel-Hamas conflict prolongs, then hopes of fall in inflation could fade away.
Due to the conflict, if inflation resumes upward journey, central banks won’t hesitate in increasing interest rates. This could have an impact on the growth of IT companies. Market Expert Santosh Singh says… “Interest rates hike and fall in ratings in the US has pushed cost of capital in the range of 4-4.5%. Most businesses have not factored in this factor.’’
Even if the Fed does not hike rates further and cost of capital remains high for next 6-12 months, even then it could have a significant impact on companies’ capital expenditures. Hence there is concern about underperformance in the IT sector, he adds.
Not only that, there has also been a reduction in the headcount or employee numbers of all the top IT companies. Infosys has even stated that their bench strength is sufficient. The company will not be visiting colleges for hiring this year.
Now the big question is if the outlook for the entire sector is not good, how should one strategise investment this sector?
Santosh Singh believes that after quarterly results, stay away from the top 4 IT giants, including Tech Mahindra. However, if there is reversal, meaning there is improvement in the sector, Ten HCL Tech will be the first preference. Zensar Tech, KPIT Tech, Bosch, Tata Elxsi, Birlasoft, Latent View, and Coforge are preferred shares in the sector. He says, buy at a 10-15% dip. A return of 30-35% is expected in these shares over next 1-1.5 years.
So, even though the results for the second quarter were not good, the outlook for at least the next 1-2 quarters is not good either. In this situation, it is more profitable to invest in mid-cap and small IT companies which focus on products rather than just software. If your perspective is 1-1.5 year, then investing in select IT companies available a discount can help in building your portfolio.
(Disclaimer: Stocks recommendations by experts or brokerages are their own and not those of the website or its management. Money9.com advises readers to check with certified experts before taking any investment decisions.)
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