Is it time to start buying IT stocks? Macquarie’s Ravi Menon explains

Ravi Menon, IT Services Analyst, Macquarie, says that we will have to wait for the next calendar year for things to move up in IT. But he is confident that we will see double-digit growth again for even the largecaps by FY26 and FY27 and that is where we differ primarily from consensus, which is still looking at 6% to 8% kind of growth.

Menon says the pecking order is HCL Tech followed by TCS followed by Wipro and then LTIMindtree. LTIMindtree can grow the fastest among the large-caps. Among midcaps, currently, only Persistent Systems is outperforming.

What is going on with IT? Soon we will be tracking the earnings as well, but fundamentally, what is the story on the ground? Does AI continue to be a threat? Are companies evolving? Are client additions happening? Are orders flowing in?
Ravi Menon: People are coming around to the view that what we saw during COVID was not just pent-up demand, but there is a big structural change. With AI, you can see the driver for that. I think before that, people were starting to move more into modern systems. So, there was a big wave of enterprise technology spending that had started. I would think that what we have seen over the last maybe six quarters or so as a pause in demand with the sharpest interest rate increases that we have seen in the US, I think probably ever.

So, IT is thought of as capex and when interest rates go up, capex slows down, that is what we have seen. Hopefully, when the first rate cut is around the corner, we should start seeing demand pick up and I think that is what people are anticipating in anticipation of that move people have started looking at adding or cutting the underweights on the sector.

What kind of client spending is happening in the US? Till now, the data seem to be suggesting that it is not crashing into recession and things are steadier there. Is it like a leading indicator of how coming quarters for some of these larger Indian companies could be?
Ravi Menon: The economy has been strong even through the last year, but still we have not seen spending. But like you said because it is not heading to a deep recession, we can expect to see the pickup in spending much quicker and probably much sharper. I would think though that we will have to wait for the next calendar year for things to move up. But I am confident that we will see double-digit growth again for even the large-caps by FY26 and FY27 and that is where we differ primarily from consensus, which is still looking at 6% to 8% kind of growth.

Time to buy IT stocks now then?
Ravi Menon: That is what we think, yes.

Is there a demarcation when it comes to the largecap versus the midcaps in terms of the kind of growth that you are anticipating, entry points as well, or is it a blanket call?
Ravi Menon: We are very stock-selective. So, among the large-caps, we have four outperforms and two underperforms. Our pecking order is HCL Tech followed by TCS followed by Wipro and then LTIMindtree. LTIMindtree we think there have been some execution challenges post-merger, but once that is sorted out, we think that is a stock that can grow the fastest among the large-caps.

Among midcaps, currently, only Persistent Systems is outperforming. We have a neutral on Coforge and underperform on Mphasis and LTTS. We got smallcap names as well, Birlasoft and Mastek both of which rate outperform.

Follow up on the Coforge, the idea that you just spelled out. The acquisition which they did, many of these companies are operating in such niches that they are having very high growth, much higher than peers. Margin profiles are better and now this kind of acquisition is as well. Perhaps in the near term, the Street did not get it, but the management was very adamant on the benefits it could accrue over the next quarters. How did you see some of these moves?
Ravi Menon: We downgraded Coforge on the acquisition. We were “outperform” on that. I used to help run testing services. I see testing as a very commoditized service that is going away because independent testing is no longer a growth area. Perhaps for Coforge, they are hoping that they can get some through Cigniti and cross-sell. I think it is a difficult task. I have tried to do this myself. But Sudhir is a great executioner, so hopefully we will see that.

But with Cigniti remaining listed and with delisting being difficult in India, if it remains a listed entity, how do you go to Cigniti’s clients and try to sell them services from Coforge? That won’t be fair to Cigniti’s minority shareholders. So, there are some issues like that, that is why we are near-term concerned, and that is why we downgraded to a neutral.

What about your outlook in terms of the kind of commentary that you are anticipating from some of these IT companies as the earnings season kickstarts? What do you think is going to be critical to monitor?
Ravi Menon: We have seen mostly cost takeout deals. There has been no change to the demand environment, but hopefully, the drags are over and we should start seeing consulting at least picking up a little bit more. Wipro had talked about it last quarter, so I think if they continue to see that, I think that would be the early signs that demand is starting to pick up.

What about smallcap IT?
Ravi Menon: We have two smallcap names that we have rated outperform. We have Birlasoft and Mastek, both of which we rate outperform.

On average, what is it that you are expecting in terms of a constant currency sequential growth, on an average from the IT pack?
Ravi Menon: This quarter, it is funny because there is a wide dispersion. There is TCS and Infosys where people are expecting possibly 2% plus growth. HCL Tech has guided to minus 2%. We think that Tech Mahindra too will probably see a decline. So, even in the large caps, the average would not make sense. The average would probably end up being 0.5% sequential growth though, we are mostly seeing sequential growth this quarter among the midcaps. So I think that will be the case.

So, net-net should one deduce that IT is not a structural story yet, but a more tactical one right now given that in the last one week alone Nifty IT has surged up about 6% and I think 13 odd percent in the last one month?
Ravi Menon: Now on three-year view, I think there is a structural story. If you have a six-month view, I think we still do not have that, so that is how…, because we are still not seeing demand pick up materially. And I think now that the interest rate cut that we were hoping for in June is not happening and the Federal Reserve will probably cut only in September, then it is too late to affect the budget for this calendar year. So, I think only next calendar year we will start seeing improved budgets and spending.

How do you bucket companies like Tata Technologies? Super niches and not in the general IT spend kind of candidates. Do you have it under your coverage?
Ravi Menon: No, I do not cover it. Engineering services overall, though, we have a view that it is a good segment, a long runway of growth, but the valuations we think have moved up too much. And like we said, we see a big enterprise refresh in IT services and we think IT services firms will, in general, grow faster than the engineering services peers of same size and same kind of, I would say, broad-based verticals or client exposures. If you have a high client concentration or a single vertical exposure, perhaps that might be different, so that is why we have LTTS now at an underperform today because we think Persistent Systems trades at a slight premium but it is growing at twice the pace as LTTS. Last year, LTTS did just about 10% organically, Persistent did closer to 14-15% organically.