For large-cap IT investors, the wait for redemption can be a long one

—Lemony Snicket

9 March 2006.

Arsenal Stadium, Highbury, north London.

The home crowd erupted in ecstasy as the referee blew the full-time whistle. The 30,000-odd Arsenal supporters, as well as millions of football fans across the world, had just witnessed an astounding denouement in global football.

The mighty Real Madrid had been sent packing out of Champions League’s Round of 16 for the second straight year. And not just any Real Madrid team. It was the ‘Galácticos’—a shining lineup of football’s global superstars—Zinedine Zidane, David Beckham, Roberto Carlos, Ronaldo and Raul.

Few years back, Real Madrid’s larger-than-life president Florentino Pérez had embarked on his audacious Galácticos project—sign the world’s best (and most expensive) players for eye-popping fees. No questions asked.

Pérez bought Portuguese star Luis Figo in July 2000 for €62 million, a world-record transfer fee at that time. Pérez broke the record the very next year by signing Zidane for an astounding €73.5 million. Ronaldo, Beckham, Robinho and others too were recruited for head-spinning amounts over the following years.

However, the results of this policy were far from spectacular.

From the 2003-04 season to 2005-06, Real Madrid did not win a single trophy. The players and team management were regularly hounded by the press. The fans spiralled into existential anguish.

After a string of humiliating defeats, Pérez resigned in 2006. And not for the last time, the ‘buy-at-any-price’ strategy came to an ignominious end.

Does the Galácticos era hold any lessons for the millions of investors in India’s IT services giants?

Earnings vs expectations

The December quarter (Q3) is a traditionally weak quarter for the country’s IT services providers due to seasonal furloughs and lower number of working days in their bread-and-butter markets of the US and Europe. Even then, the Q3 showing by the large-cap IT companies have collectively sent out a warning plume of smoke.

The largest IT services company, Tata Consultancy Services (TCS), posted its worst Q3 revenue decline since December 2015. Q3 FY25 revenue of $7.54 billion was down 1.7% from the September quarter. This was also its worst quarterly revenue performance since K. Krithivasan took over as chief executive officer (CEO) in June 2023.

The key reason was weakness in its two major geographies—US and Europe—which account for around 78% of its topline. Revenue from its largest market US shrank 1.5% sequentially (and 2.4% year-on-year). Nearly all verticals posted a decline, led by healthcare, manufacturing and BFSI.

Its Bengaluru-based peer, Infosys, clocked a revenue growth of 0.9% in dollar terms, beating analyst estimates. However, it was optically a bit misleading.

“The entire beat was led by higher revenue from sale of third-party items bought for service delivery to clients that contributed incremental USD 78 mn to revenue versus reported incremental revenue for the quarter of USD 45 mn,” analysts at Kotak Institutional Equities said in a note.

On similar lines, HCL Technologies reported a 2.5% sequential growth in revenue at $3.53 billion, but this was boosted by one-month inorganic contribution from its acquisition of the assets of Communications Technology Group (CTG) from Hewlett Packard Enterprise (HPE), completed in December 2024.

Wipro’s Q3 revenue dropped 1.2% to $2.6 billion, while Tech Mahindra saw its topline decline 1.3% sequentially to $1.56 billion.

“While large-cap IT firms’ topline growth continued to be lacklustre, commentary on technology spends has improved in key geographies and verticals such as BFSI (banking, financial services and insurance),” Christy Mathai, fund manager—equity, Quantum Mutual Fund, told Mint. “Deal total contract values (TCV) have seen an uptick in some cases and there is a possibility of better revenue conversion, going forward. Margins have improved for the majority of players on expected lines driven by utilization improvement and employee base optimizations,” he added.

Net profits too were healthy across the board, propelled by the strong margins.

TCS’s earnings before interest and taxes (Ebit) margin increased 40 basis points (bps) quarter-on-quarter to 24.5%, but was still below its aspirational range of 26%—28%, while that of HCL Tech climbed 90 bps to 19.5%.

One basis point is one-hundredth of a percentage point.

Wipro’s Ebit margin improvement of 70 bps to 17.5% was particularly impressive as it had rolled out salary hikes effective 1 September 2024. The company highlighted that margins in Q4 may be in a similar range as in Q3.

That said, one of the key growth levers of IT companies was a mixed bag at best.

Deal with it

While companies reported robust deal wins, the lack of mega deals combined with client-specific ramp downs have spooked the market.

TCS’s deal TCV at $10.2 billion, up 25% year-on-year, was impressive, though there was an absence of “mega deals”. The management said deal cycle reduction indicates improved decision-making by clients.

But since its mega-deal with BSNL (TCS signed a ₹15,000-crore deal with BSNL in 2023 to set up 4G sites and data centers across India) in the domestic market is 70% completed, analysts expect the impact to be felt from the March quarter (Q4) onwards.

On the other hand, Infosys’ TCV tumbled 22% on-year to $2.5 billion.

“Number of large deals declined to 17, lower than the average in the past 4-5 years. New deal TCV increased sharply, up 57% q-o-q. However, we do note that renewal TCV of USD 2.5 mn declined 36% q-o-q and 2% y-o-y. It is difficult to assess the reason for moderation in renewal TCV,” Kotak Institutional Equities stated.

The company increased its FY25 guidance by 50 bps at the higher end and 75 bps at the lower end.

“This suggests that recovery is still away in the medium term. The North America market has shown some improvement in Q3, but we need to see sustained long-term growth here. Large deal wins were steady in Q3 but annual guidance suggests that there would be a dip in revenue in Q4 due to continued furlough impact. Despite a rise in revenue guidance, no change in the margin band suggests incremental cost pressure, especially for employees with AI skillset (comes at a premium pay scale),” Elara Capital said in a note dated 17 January.

Wipro’s deal TCV at $3.5 billion was down 7.3% year-on-year. It has guided for (-)1% to 1% sequential revenue growth for Q4, disappointing some analysts as the upper end of the guidance implies a modest 0.6% on-year growth in constant currency terms for the March 2025 quarter.

That said, most companies said they are seeing early signs of a revival in discretionary spending in key verticals like BFSI and retail. Also, there is an increased demand for offerings related to application modernization, cloud, and data, driven by the adoption of generative AI by clients.

“From a vertical perspective…deal wins have been good in BFSI, consumer business. And in fact, in almost all verticals, there is an increase in deal wins compared to the previous quarter. From a geography perspective, Europe has one of the best deal wins,” TCS CEO Krithivasan said at the company’s post-earnings conference call.

The management of other companies too exuded confidence of 2025 being a better year than 2024.

But despite the multi-billion-dollar deal pipeline, early signs of demand recovery and uniformly positive management commentary, why is the market treating large-cap IT stocks with so much disdain?

V for valuation

Memory is often the first casualty of a raging bull market, but those who have been around for long, fondly remember a time when large-cap IT stocks used to trade at 15-20 times earnings.

The inflection point came at the onset of the covid-19 pandemic, when the sudden seismic shift towards digitalization turbocharged sentiment towards technology stocks the world over, including in India. The subsequent exhilaration around generative AI, machine learning and other technologies of the future led to the price-to-earnings (P/E) multiples of these IT stocks doubling compared to their pre-covid levels.

The situation was even more extreme in the mid- and small-cap IT universe, where some counters are currently priced at nose-bleed levels.

A high P/E is invisible when the party is in full swing, but when all the good news is already priced in, even a hint of trouble on the execution front can lead to a cascade of pain. Which is what happened in the aftermath of the Q3 results.

“Elevated valuations are indeed influencing the performance of large-cap IT stocks. The increase in valuations reflects heightened expectations for growth, partly due to accelerated digital adoption during the pandemic. However, as global economic conditions stabilize, the disparity between high valuations and actual earnings growth has become more pronounced,” Anirudh Garg, partner and fund manager at Invasset PMS, told Mint.

“This misalignment has led to subdued stock performance, as investors reassess the sustainability of such valuations. The recent decline in Infosys’ share price, despite an upward revision in revenue forecasts, underscores market sensitivity to earnings quality and growth prospects. Therefore, while the sector’s long-term outlook remains positive, current rich valuations may continue to weigh on stock returns in the near term,” he added.

Even the broader Nifty IT index may be flashing signs that the party is nearing its end.

“Nifty IT has outperformed Nifty 50 by more than 10% since our overweight stance in July/August 2024. Going into 3Q earnings, Nifty IT outperformance was ~15% in December 2024 and suggests many of the positives were getting priced in,” Abhishek Shindadkr, research analyst (IT), InCred Capital, told Mint.

The swelling of the P/E ratios of large-cap IT stocks is concerning news in itself. But combined with challenges on the earnings front, investors are staring at a deadly combination.

Many market veterans consider the price/earnings-to-growth (PEG) ratio, which measures a stock’s P/E against the estimated annual earnings per share (EPS) growth, as a better judge of a share’s valuation. In simpler words, if a stock is priced richly at 30 P/E, but the EPS growth too is at a healthy 30%, it translates into a PEG ratio of 1, which makes the stock fairly valued despite its optically high P/E ratio.

Going by the EPS estimates of various brokerages, large-cap IT stocks are currently trading at PEG ratios of 3-4, which crosses the thin line between optimism and delusion.

With the weight of financial history against them, many obstinately optimistic investors are now casting wistful glances at a maverick realtor-turned-politician half a world away.

Make IT great again

Donald Trump’s second presidency began in trademark fashion, with a flurry of executive orders. It whiplashed global markets. But Indian IT investors are fervently hoping that his pro-growth agenda, coupled with a surging dollar, will give a much-needed boost to India’s software services giants.

Many experts, however, are a bit more cautious.

“The re-election of President Trump introduces a mixed outlook for India’s IT sector. On one hand, pro-business policies, including potential corporate tax cuts and deregulation, could stimulate US corporate spending, benefiting Indian IT service providers. Conversely, discussions within the administration about tightening H-1B visa regulations may pose challenges, potentially affecting the workforce dynamics of Indian IT firms,” Invasset’s Garg pointed out.

Regarding currency fluctuations, the depreciation of the Indian rupee enhances the competitiveness of Indian IT companies by increasing export revenue.

“Analysts suggest that for every 1% depreciation in the rupee, there is typically a 0.5% increase in revenue and about a 1.5% rise in profit,” he added.

Quantum MF’s Mathai agreed that currency depreciation remains a positive in the near term, but added that over a period of time, these benefits are passed on to clients. “News flow from the US continues to be important. But unlike the first term of President Trump, IT services companies are better prepared with increased localization,” he said.

“IT stocks have rallied in the past one year on the expectation of improving client environment in key geographies and possible earning uptick but that has not materialized. Going forward, earnings growth has to pick up to justify current valuations,” he added.

Many experts maintain that while strong deal pipelines and the accelerated adoption of AI by clients bode well for the Indian IT sector, investors should adopt a selective approach, focusing on companies with diversified client bases, strong digital and AI capabilities, and prudent risk management strategies to navigate the current business landscape.

But those who bought at the peak of the post-covid hype can expect to see some price/time correction in their portfolios.

As Real Madrid’s Pérez would attest, buying at fanciful prices, no matter how compelling the underlying story is, is hardly a guarantee of fanciful results.