Why did JP Morgan downgrade the Indian IT sector

About 6-8 months back, many of the global brokers had gone underweight on India at a macro level. Now the action is getting a lot more sector specific. Global brokerage house, J P Morgan has downgraded the IT sector to “Underweight” due to concerns over growth and margins. As JPM put it very succinctly, the glorious days of high growth combined with high operating margins may be over for now. Both assumptions may be under pressure.

According to JP Morgan, the high levels of revenue growth may come under question due to the anticipated slowdown in the US economy amidst a spike in interest rates. In addition, inflation may take longer to taper so the high EBIT margins may also be tough to sustain. In fact, JP Morgan is targeting 10-20% downsides in valuations for leading IT companies like TCS, Wipro and HCL Tech. However, JPM remains positive on Infosys in the IT pack.

According to JP Morgan, the downgrade risks apply to all the stocks in the IT sector, but the negative impact may be lower in the case of select stocks. For instance, JPM remains overweight on Infosys, as it still has room for growth, and Tech Mahindra due to its strong franchise in the 5G telecom space. In the mid-cap IT space, the brokerage house is more positive on Mphasis and Persistent, where the business models are more defensive.

With all the headwinds, the relatively expensive valuations meant that IT was the most vulnerable for valuation mean reversion. For instance, if you look at the calendar year 2022, IT sector has underperformed the Nifty with losses of 27%. This is the worst performance among key sectors and it also highlights that current valuations may be too rich and hence unsustainable. Even the FPI selling has been very sharp in IT stocks.

JPM also points out to the dichotomy of low-end value creation and steep valuations as being mutually contradictory. For example, the Indian IT stocks with their relatively staid outsourcing models were trading at a premium to their digital peers as well as to companies like Accenture. In short, the software service providers were getting the valuations that global digital players and enterprise software names were getting; something unsustainable.

In this light and the macroeconomic headwinds, JPM feels that the growth assumptions are too rich and steep. For example, the market valuations are still building in growth of 6% to 13% for large caps and 14% to 33% for mid-cap IT names. JP Morgan believes that such steep valuation expectations may be hard to sustain if the global IT spending and digital spending was to taper in the next few quarters. JPM expects things to worsen in FY23.

On the subject of the benefits of a strong dollar, JPM feels the net impact would be marginal. For instance, the USD/INR may have appreciated by 3% in the previous quarter, but cross currency fluctuations had offset the impact since the top Indian it companies today have substantial non-US revenues too. It is not just JP Morgan, but even large domestic institutional brokers like Kotak are cautious about IT stocks in India.

In fact, Kotak Institutional Research has also voiced similar concerns. According to Kotak, the margin risk may have been priced into the recent correction, but interest rate hawkishness and the likelihood of recession remain X-factors. That is yet to be factored in and that may cause pressure on the stock prices of IT stocks. Certainly, Indian IT stocks appear to be up against a tough FY23, due to the impact on top line and also on the bottom line.