Hope is all around, especially if you were a tech sector investor last week, as IT stocks reacted positively to Infosys and TCS results, while Wipro ADR shot up 16 per cent on Friday (results came in after Indian markets closed). However, does this hope rally have legs to stand on?

Yes, results were in line (albeit on weak expectations), margin trends were better and attrition has declined considerably. But if one is not short of memory, one would recollect that in CY2022 business was booming, margins were falling short and attrition was at multi-year highs. So, as a corollary, based on better margins and low attrition this time, one can make an argument that underlying business trends are not as strong as the market reactions seem to be proposing.

During a slowdown, companies step up efficiencies, cut costs (including deferring hikes) to boost margins. Employees, mindful of the circumstances, are less likely to change jobs, resulting in reduced attrition. So focussing on the margin improvement in recent quarter may be a case of missing the wood for the trees. It would be worth noting that during the time in the last 15 years when IT Services companies have delivered well on business performance and stock returns, margins have actually declined from highs of around 30 per cent for companies like TCS (24- 25 per cent now) and Infosys (20-21 per cent now).

ACTION, NOT WORDS

So, what can help affirm the underlying trend in the sector to get a holistic picture? Look at what managements are doing rather than saying. In this case, it is what they are doing about headcount. Analysis of data going back to nearly two decades, indicates a clear high correlation between headcount and business trends for IT services companies. The correlation in roughly the last two decades ranges from 0.96 to 0.99 for the top four4 Indian IT companies (see charts).

So, if one were to go by this, given the headcount declines for Infosys, TCS, Wipro and HCLTech YTD in FY24, one may need to reassess whether the current rally can sustain. This is especially considering the fact that the gap between business trends and valuation is wider than ever (see charts).

For instance, for the large IT players, which have reported headcount declines YTD (which did not happen even during the 2008 slowdown), the PE ratio is very close to historical highs, while employee and revenue trends are at historical lows.

Productivity buzz

What about productivity? During the previous decade, the IT services industry has made a successful transition from legacy business to a digital-focussed business. This transformation hasn’t altered the correlation between business trends and headcount much. In fact, the employee productivity for companies has largely declined or stayed flat, barring Infosys, in the last 10 years. For instance, in the case of TCS productivity has declined from about $50,000 per employee in FY13 to $47,000 in FY23, while it has stayed flat for HCLTech at $55,000 and Wipro at $41,000. Infosys saw improvement from $48,000 in 2013 to $55,000 now.

Volumes and currency depreciation have made up for the lack of improvement in productivity. And managements’ own comments indicate AI is a potential long-term story rather than a case of any near-/mid-term game-changer.

In this context, it would be worth revisiting the hope rally in IT stocks that is characterised by historically high valuation amidst historically weak business trends. A quick turnaround is not impossible, though looking at data, it does appear so.

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