Mini wreck. HCL Technologies pre-announcement: Is it the canary in the coal mine?

A mere 0.5 percentage point reduction in FY23 revenue growth guidance from HCL Technologies (reduced to 13.5 per cent from earlier 14 per cent) ideally should not be big news. It however caused a mini-wreck of sorts in the Indian IT sector, pulling the  Nifty IT index down by over 3 per cent on Friday. HCL Tech of course led the pack with near 7 per cent decline.

Is HCL Tech the canary in the coal mine when it comes to the IT sector, or have the markets overreacted? For reasons mentioned below, it could be the former, and investors must get cautious about the possibility of more pain in the sector over the next two-three quarters.

Firstly, there is an overwhelming indication that an economic slowdown is taking hold in the US and European economies (main markets for Indian IT), the true extent of which will be known and felt only next year. Even one quarter back (at the time of the June Q earnings release), large US banks were sending indications that contradicted a slowdown, with solid earnings beat driven by strong consumer spending.

Sullen mood

However, just last week, there were indications of a more sullen mood with CEOs of some of the largest banks like Bank of America and Wells Fargo mentioning cooling consumer demand as well as their expectations for a recession in the US in 2023. This is significant for Indian IT for two reasons – one, the bank CEOs with their data on consumer/business savings and spending have some of the best insights on key trends driving the economy. Two, the BFSI sector is one of the biggest revenue segments for Indian IT companies. For example, top companies like TCS, Infosys, and Wipro derive over 30 per cent of revenues from this segment, and HCL Tech well over 20 per cent. Thus, if your largest customer geographies are seeing a slowdown, and your largest customers are feeling the pinch, they will get cautious about their spending and have extra levels of scrutiny when it comes to spending on your services.  IT budgets are more resilient than other spending by corporates, but a slowdown will have an impact on this too.

Secondly, the slowdown is one part. The other part is being priced for a slowdown, which does not appear to be adequately reflected for many stocks in the Indian IT sector. Compared to global tech, Indian IT has still outperformed, the correction notwithstanding. For example, on a YTD basis, TCS is down 14 per cent, compared to its close peer and industry leader Accenture (NYSE listed) down by 29 per cent, despite the fact that Accenture has delivered better revenue and earnings growth over the last year. TCS also trades at a premium despite underperforming on growth versus Accenture on a five-year basis. This is reflective of the broader relative outperformance of Indian IT stocks when compared to global IT stocks. While some midcap Indian IT stocks and large players like Wipro have had some significant correction, for many stocks, their valuations are still high relative to long-term growth prospects, and do not appear to factor in the possibilities of impact to business from a slowdown.

HCL Tech’s pre-announcement also indicates how quickly things can turn around before investors can react. It was only in mid-October that the company beat market expectations by increasing its FY23 revenue growth guidance from 13 per cent to 14 per cent, but within weeks, has lowered it citing impact of slowdown.    

What should investors do?

How a slowdown plays out and to what extent it impacts the business of Indian IT companies is debatable, but not factoring in the risk means investors are left with no cushion if the risks do materialise. At bl.portfolio, we had started getting cautious about the Indian IT sector since the middle of 2021 as valuations had run way ahead of fundamentals. We further re-iterated our cautious stance earlier this year. The risk-reward continues to remain unfavourable for most stocks in the sector given the uncertainties of 2023. Our current expectation is for the sector to bottom out sometime in 1H of 2023, by when the impact of the slowdown in the US and European economies will more clear, and it would be time then to look forward to a recovery.  

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