Sector Watch: What’s in store for IT stocks and what are the top picks?

The Indian technology and software services sector has seen a phenomenal bull run since the beginning of 2020. Deeper penetration of 4G technology and the restrictions induced by the Covid-19 pandemic including remote working has resulted in strong earnings growth and margin improvement for some Indian IT services companies, leading to a significant re-rating of the sector since early 2020.

The BSE Information Technology index has risen 141% since the beginning of 2020 to 38,300-38,350 levels. The gains were led by Wipro, Infosys and Tech Mahindra among the frontline stocks, and by Mphasis, Persistent Systems and Mindtree in the mid-cap space.

Now, Nomura Financial Advisory and Securities expects a multi-year growth cycle for Indian IT services companies. The investment advisory firm anticipates strong demand tailwinds for the sector, driven by acceleration in spends by global enterprises in the digital and cloud transformation space.

Nomura has initiated coverage on top 10 IT services stocks with a ‘buy’ rating on Infosys, Wipro and Tech Mahindra in the large-cap space, and Persistent and Mphasis in the mid-cap space.

In a fragmented $1-trillion global IT services sector, large-cap Indian IT services companies have been consistently gaining market share, which is expected to increase further, Nomura said.

Strong demand environment

The demand outlook for Indian IT services remains strong in 2022, particularly aided by the rising penetration of cloud adoption, said Abhishek Bhandari, senior analyst at Nomura.

International Data Corporation (IDC) expects the managed cloud services industry to double in terms of revenue and IT outsourcing penetration to increase from 23% to 41% over CY20-CY25 estimates. Moreover, other early demand indicators like deal wins and strong hiring continue to point upward.

A study of the tech spend commentary of clients indicates a robust spending outlook for 2022. Smaller-sized deals continue to outpace the large ones, which is positive for mid-cap stocks and should help them grow faster than large caps in the current tech upcycle.

“We expect the industry’s revenue growth rate to be approximately 1.5 times of pre-COVID levels over CY22-24f. We expect large caps to increase their market shares in the global IT services industry from 5.7% in CY20 to 7.5% by end-CY23f,” said Bhandari, referring to forecasts for 2023 and 2024.

Price hikes, margin pressures

Rising attrition and strong headcount additions pose near-term risks to margins, while supply side-led margin pressure will likely be transient.

“Offsets are possible in the form of pricing increases (given client acceptances), higher offshoring, the ongoing pyramid optimization and automation. We believe the scope of margin expansion over the next two-three years is the highest for Tech Mahindra in large caps (compared to FY21 levels),” said Bhandari.

“For Wipro, we expect margins to improve once the Capco acquisition headwind is over,” he added.

EPS upgrade

The IT services sector may continue to see an EPS upgrade cycle over the next two years, with Nomura expecting FY23 and FY24 EPS estimates at 14% premium to consensus EPS for the large-cap IT services stocks and 20% premium for the mid-cap stocks.

“We base our valuation on a PER methodology. We have used a three-stage growth model, assuming high growth phases over the next 10 years, followed by steady growth,” said Bhandari.