JP Morgan downgrades Indian IT sector on margin, revenue concerns

Global rating agency JP Morgan has downgraded the Indian information technology (IT) sector to ‘underweight’, citing that the industry faces margin headwinds in the near-term and the revenue constraints in the medium-term due to surging inflation and supply chain issues in the backdrop of Russia-Ukraine war. The brokerage has downgraded four companies — Tata Consultancy Services, HCL Technologies, Wipro and L&T Technologies — to "underweight" from "neutral", while it maintained an overweight rating on Infosys, Mphasis, Persistent Systems, and Tech Mahindra with reduced target prices.

Analysts at JP Morgan have downgraded Tata Consultancy Services (TCS), the country’s largest software exporter, to "underweight" rating from "neutral", but maintained "overweight" on Infosys, the second biggest IT firm. The agency expects industry margins to narrow due to high attrition rate and talent management that has pushed up costs of hiring and retaining employees. However, Infosys’ margin reset is early and allows the IT major to invest and maintain growth, it added.

“Rising margin headwinds in the near term and revenue headwinds in the medium term from a potential macro slowdown will mean that the sector’s earnings upgrade cycle is behind. We see peak revenue growth behind us and EBIT margins trending down from inflation, mean reversion," Ankur Rudra and Bhavik Mehta of JP Morgan say in a report.

The analysts warned that Indian IT companies have started to face slowdown since the March quarter of 2022 (Q4 FY22), which is likely to worsen into FY23 partly due to a potential decline in orders from the key market such as the United States. “Indian IT growth was accelerating till 3Q22 and has begun to slow down from 4Q22, which is likely to worsen into FY23 amid worsening macro. With peak sector growth behind, growth deceleration should continue to weigh on sector multiple," as per the report.

"While the bottom-up outlook remains positive from most Services, Software and SaaS names YTD, and the tech spending cycle remains buoyant structurally, we feel there are more downside risks to current earnings assumptions," it adds.

Weighed down by the report, the BSE IT index crashed 5.25%, or 1,600 points, to settle at 28,868 levels in a bearish trade on Thursday. The IT index was the worst performer on the sectoral front, while the benchmark indices BSE Sensex ended 1,416 points, or 2.61%, lower at 52,792. Investors lost ₹6.58 lakh crore in value, as market capitalisation of BSE listed companies dropped to ₹249.20 crore on May 19 from ₹255.77 lakh crore on May 18.

The IT companies have underperformed the benchmark indices in the calendar year 2022 as weak earnings outlook and shrinking margins dented investors’ mood. On a year-to-date basis, the BSE IT index has fallen 11%, while it dropped 10% in the past six months. However, in the past one year, it has given a positive return of 6.5%.