IT Stocks: Time to Book Gains in IT Stocks? This broker just cut targets by 18-26%

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NEW DELHI: While the majority continues to see the outlook for the IT sector as strong, Nirmal Bang Institutional Equities has downgraded the sector to ‘underweight’ (UW) on a 12-month basis and proposed to reduce exposure, particularly in Tier -2-IT shares the first half of this fiscal year.

In a note to clients, the brokerage firm said likely strength in H1 2023 should be used to reduce Overweight (OW) positions, particularly in expensive Tier 2 IT companies, although it believes that the sector has relative earnings resistance to certain domestic sectors in the short term.

The Nifty IT Index is up almost 144 percent between January 2020 and March 2022. The NSE barometer Nifty50 is up around 44 percent, while the Nifty Bank is up 13 percent over the same period.

Tier 1 and Tier 2 IT companies are now trading at 28x and 39x 12-month forward PE, respectively.

Nirmal Bang said Nifty IT’s outperformance was due to pandemic-driven digital transformation (DT) services, profit acceleration and significant multiple expansions on the back of unprecedented monetary stimulus in the US and Europe.

“The DT tide over the past 24 months has lifted all boats (including weak ones) and will likely keep them afloat for another 6-12 months. However, the accelerated normalization of monetary policy in the US increases the likelihood of a hard landing there and consequently the low likelihood of positive surprises on the fundamental side over the next 12 to 24 months,” it said.

Nirmal Bang said that after multiple upgrades, consensus estimates point to strong revenue growth and stable margins in FY23 and FY24, underestimating the risks in FY23 to both growth and margins.

The brokerage said DT services will remain a key theme over the next few years, but “willingness to spend” is constrained by “ability to spend” as corporate customers grapple with earnings pressure from commodity and wage inflation. Supply chain challenges, reduced consumer spending power, higher interest rates and likely below-trend growth in western developed markets.

“This will mean, in our view, that the current peak earnings of S&P500 companies are unlikely to continue. We also believe that the broader picture of corporate customer wins in the West may be looking worse. Post FY23, we are seeing customers moving away from the current democratization from a ‘capabilities/capabilities’ focused provider model to a more differentiated ‘ability to deliver’ based model,” it said.

The Russia-Ukraine conflict could also exacerbate the already stagflationary global macrostructure, although there could be a short-term surge in revenues due to the likely reallocation of demand away from Eastern Europe, it said.

“We are therefore underweight the sector again from a previously briefly overweight position. We favor Tier 1 companies over Tier 2 primarily due to multiple reductions in target PE. We continue to maintain TCS as our industry benchmark. However, we now rate TCS at a target 12-month forward PE of 24.2x to FY24 EPS. With the exception of HCL Tech, Tech Mahindra and Wipro (‘Collect’ ratings) we have a ‘Sell’ for all others under coverage,” it said.

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Source: Nirmal Bang Institutional Equities

The brokerage firm said it expects the vendor consolidation issue to make a comeback after FY23.

Most successful Indian Tier 2 IT companies have largely implemented the “value creation framework” – recruiting executives from Tier 1, offering strong incentives to them and the sales teams, and reinforcing horizontal as well as vertical skills, Nirmal Bang said, adding that they were also additionally driven by the DT tsunami.

“You’ll probably have a good FY23, but that’s already priced in; Risks to FY24 growth/margins and PE are not,” it said.

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