IT stocks might have soared on PE expansion, but challenges persist: Nirmal Bang

“Price-to-earnings ratio (PE) multiple expansion explains the entire return of both tier-1 and tier-2 IT stocks over the last 12 months as consensus FY25E earnings have seen downgrades,” said Nirmal Bang in its report on March 15.

The Nifty IT index has risen nearly 31 per cent, slightly above the 30 per cent gains of the equity benchmark Nifty 50 in the last one year.

Stocks such as Persistent Systems (up nearly 86 per cent), Coforge (up 55 per cent), L&T Technology Services (up 53 per cent) and HCL Technologies (up 53 per cent) have seen strong gains over the last year despite persisting concerns over weakness in demand in key markets in the West.

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While it appears investors are placing greater emphasis on the valuation multiples rather than the actual earnings growth of the IT companies, strong domestic inflows into equities could be another factor behind the rise in IT stocks, said the brokerage firm.

“While some in the market believe that PE multiple expansion is a precursor to the start of a consensus earnings upgrade cycle for FY25/FY26, we remain sceptics. We believe it has more to do with strong domestic inflows into equities,” said Nirmal Bang.

“The tier-2 PE premium of 32 per cent currently versus the tier-1 is due to the skewed inflow into mid-cap mutual funds as much as because of better future growth prospects,” the brokerage firm added.

The brokerage firm underscored that the market is assuming the next financial year (FY25) to be slightly better than FY24 and there would be a pent-up demand-driven revenue spike in FY26.

While the PE multiples may require a material upgrade to FY25 and FY26 estimates for meaningful returns, the brokerage firm sees limited scope for a material upside to the earnings estimate in FY25 and FY26 due to elevated interest rates and uncertainty around the economic policies in the US.

Also Read: IT sector outlook: Worst may not be over; Nirmal Bang sees earnings downside risk for FY25-26

“Going by the second half of the year 2024 recovery talk by most IT players, a high probability of ‘higher for longer’ Fed Funds rate in the US due to recent hotter inflation prints there and uncertainty around economic and immigration policies of the next US administration, we do not think there is a material upside to the earnings estimate in FY25/FY26,” said Nirmal Bang.

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Nirmal Bang believes earnings prospects for some companies could be better than their pre-pandemic phase but most others will revert to pre-pandemic levels or worse.

As per the brokerage firm, a study of the last 10-year trends reveals that the Nifty IT index has performed better than the broader Nifty index, but this was mainly driven by the digital transformation-related phase during the calendar years 2020 and 2021. Outside of this period, the Nifty IT index has lagged.

Another study over the same period shows that Indian IT stocks are currently trading at significantly higher valuations compared to the average multiples from the years 2015 to 2020. While some companies have improved their earnings prospects, it’s not as dramatic as bullish investors believe, and not all companies have experienced this level of improvement, the brokerage firm pointed out.

“A 10-year study of valuations and earnings growth indicates that Indian IT stocks are currently trading at +1.9SD (standard deviation) to +10.6SD higher valuations compared to the mean multiples during the FY15-FY20 period. Yes, we would admit that certain companies have undergone a structural change for the better in their earnings prospects compared to that period, but not to the extent that the bulls assume and not all of them,” said Nirmal Bang.

Nirmal Bang believes the market is too optimistic about the growth prospects of the tier-2 IT companies over the next five years.

The brokerage firm expects a 4-7 per cent constant currency (CC) revenue growth guidance by both Infosys and HCL Tech. Even this may be at risk if the Fed Funds rate is not cut materially, if there is a recession or if enterprise customers freeze up due to uncertainty around the US election.

Also Read: Delayed rate cuts negative for Indian markets; investment opportunities galore in several sectors: Hemant Sood of Findoc

“We see ‘slower for longer’ demand conditions through 2024 that could pare consensus earnings expectations,” said Nirmal Bang.

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Disclaimer: The views and recommendations above are those of individual analysts, experts and broking companies, not of Mint. We advise investors to check with certified experts before making any investment decisions.

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Published: 17 Mar 2024, 04:53 PM IST

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