Risk-Reward Less Favourable For Indian IT Firms, Says Morgan Stanley
The IT sector will continue to see headwinds in the near term and the earnings downgrade cycle will also continue: Morgan Stanley
Morgan Stanley downgraded two Indian IT firms to its lowest rating as it expects subdued performance for the sector to continue in the next two quarters.
The sector will continue to see headwinds in the near term and earnings downgrade cycle will also continue, the financial services provider said in a report. It also slashed target prices for all the IT stocks in its coverage.
Near-term headwinds and a lack of catalysts could keep the IT industry's performance under pressure, Morgan Stanley said. It listed key reasons for its forecast:
Macro risks to impact demand. Historically, revenue growth has been impacted during GDP downgrade cycles. It expects this to play out in the first half of 2024 leading to mid- to high-single-digit revenue growth in FY24.
Consensus earnings have declined in the last two quarters but sees room for more downgrades led by both revenue/margin cuts for FY24.
Valuation multiples have come off but stocks still trade at premiums to historical averages. While Morgan Stanley expects the slowdown to be a shallow one in the current cycle, slower growth for a prolonged period could lead to a sharper de-rating.
Historically, stocks tend to price in recovery or slowdown three-six months in advance, and Morgan Stanley expects growth to bottom out in the June 2023 quarter so it doesn't see any positive triggers over the next six months, keeping the sector performance subdued.
Morgan Stanley’s Order Of Preference
Morgan Stanley said it prefers large caps over mid caps. Within large caps, Tech Mahindra Ltd. and Infosys Ltd. lead the pecking order.
While Tech Mahindra has good growth visibility and reasonable valuation, Infosys’ market share gains, margin bottoming out and valuation discount to Tata Consultancy Services Ltd. are an advantage, it said.
The research house downgraded Wipro Ltd. and HCL Technologies Ltd. to ‘underweight’ as it sees sector valuation to come off and the discount to TCS/Infosys to likely expand in a tough environment.
It retained ‘equal-weight’ on TCS, but with a preference for Infosys.
“Within mid caps, we maintain Mphasis as the only ‘overweight’ and align L&T Infotech’s rating with Mindtree’s to ‘equal-weight’, and maintain Cyient as ‘underweight’.”
Morgan Stanley’s view on IT stocks concurs with that of Nomura. “Fast changing macroeconomic conditions, hawkish [U.S.] Fed stance to tame inflation through continued interest rates hikes and profit warnings by corporates across the globe seem to suggest tough days are ahead for tech spending,” Nomura had said in a May 23 report.
Motilal Oswal, too, cautioned that macro challenges would hurt IT margins in the medium term, but maintains a "positive stance" on the sector.
On the contrary, the Information Services Group and Gartner are betting on strong demand environment for the sector. ISG expects supply constraints to ease gradually but identified attrition as a key challenge, including external factors such as cross-currency movement and slowdown in China rather than demand slowdown. Gartner has also raised its 2022 and 2023 growth estimates.
