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The earnings season for IT majors is over, with most reporting lacklustre results, and outlook none-too-optimistic. It is now clear that FY25 is unlikely to see any meaningful recovery.
In businessline’s January 14 edition, we had pointed out ‘Why the IT stocks rally may be on wobbly legs’. This has played out in the last two months with the IT rally petering out, with most stocks and the Nifty IT index giving up the gains made in January and yielding negative returns YTD. What’s ahead?
Valuations still high
Apart from factors such as lacklustre guidance, weak trends in head count, order books not translating to better revenues, and uncertain global macro-economic outlook, there is one more metric that doesn’t look encouraging — valuation.
The post-Covid digitisation boom rally in IT stocks got stretched beyond reasonable limits and result is there for everyone to see — the timewise and absolute corrections in most IT stocks since January 2022. And, valuations are still expensive relative to pre-Covid levels even as business trends continue to remain weak.
Sentiment, liquidity, price insensitive buying due to the rise of passive investing, etc., are some of the factors that can explain this premium. Can this valuation premium sustain? Here is one thing that can give you a perspective — the valuation of Accenture.
Cues from leaders
Accenture is the global leader in IT services and consulting, followed by TCS. Given that their revenue/earnings growth have been largely similar over many years, their valuation differentials cannot diverge too much. The 10-year EPS CAGR (FY14-24) of Accenture is 10 per cent. For TCS, too, it is the same 10 per cent, while the 5-year EPS CAGR (FY19-24) of TCS is 9 per cent, almost matching Accenture’s 10 per cent.
A look at historical data (see chart) show that their PE valuation has largely converged, every time they have diverged. In some of the years running up to Covid, Accenture used to trade at premium to TCS. This was even though TCS had superior margins versus Accenture. Amongst other factors, a key aspect underlying this premium valuation for Accenture was to its industry leadership and its revenue having a much higher contribution from the consulting business (premium/high-end business). This can be gauged from employee productivity data (revenue/employee), which is around $87,000 for Accenture, significantly higher than TCS’ $48,000.
However, post Covid, this premium has been put to test, with TCS trading at a premium for longer periods. But here is one thing to note — the current valuation premium of TCS over Accenture (20 per cent on trailing PE and 12 per cent on one year forward PE) cannot sustain for long. With their long-term growth likely to be similar as things stand now, this gap will get bridged one way or the other as the market pendulum keeps swinging between efficiency on one end and inefficiency on the other.
The benchmark
Hence, from here on, either the stock of Accenture has to move up or TCS has to go down further for the valuations to converge.
Given that TCS sets the benchmark for valuation in Indian IT stocks, if it falls further, needless to say other IT stocks too will slide. Historical data shows how other big IT players have mostly traded at a discount to TCS. There is no reason for this discount to get bridged given the far better execution track record, consistency and superior margins for TCS.
Of course, TCS can move up, implying that other IT stocks too can. But current fundamentals and valuation do not appear to favour such a move. But whichever way, the direction for the moves ahead depend on Accenture and US markets. While Indian markets may decouple to an extent from global markets, IT stocks cannot.
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