Five reasons why you should avoid investing in IT stocks

All is not well in the IT sector. Stocks of the top five IT firms TCS, Infosys, HCL Tech, Wipro and Tech Mahindra have lost up to 24 per cent in the last one year, and stare at more losses in the months to come with IT companies coming out with profit warnings and revising downwards their revenue guidance for fiscal year 2017.

Brokerage Centrum Broking noted that top five IT companies have seen a steady moderation in growth momentum compared to their heydays owing to slowdown in select verticals, client specific issues, M&A consolidation in select industries (Healthcare) as well as pricing pressure (especially commoditized Services).

The brokerage believes industry leaders Infosys and TCS will deliver 8.5-9.5 per cent YoY dollar revenue growth in FY17, but laggards are set to face much tougher times.

Below are five challenges that IT firms are grappling with:

1) Global peers catching them fast

While Indian software services firm continue to spread wings in the global market, the growing prominence of major global (Accenture, Cognizant) and niche players (EPAM/Luxoft/Virtusa) may slowdown their pace of growth. Global brokerage firm Nomura, in fact, said the trio of EPAM, Luxoft and Virtusa grew at Compound Annual Growth Rate (CAGR) of 26 per cent over FY13-16 (twice the pace of tier-I IT firms) and are expected to sustain the momentum. On top of it, these new challengers have tier-1 IT firms' underperforming segments (BFSI/TMT, ADM and Europe) as their growth drivers.

2) Digitisation slouching along

Software industry body  Nasscom believes by 2025, 60 per cent of overall technology and business services enterprise spend will be on digital technologies, translating to CAGR of 22 per cent on digital and -4 per cent on traditional IT spend over 2014-25. Although Indian IT firms are going digital, global players enjoy an edge in early-stage digital opportunities thanks to significantly higher exposure to new work around digital transformation, more experienced and skilled manpower and near-shore p-resence, said Nomura.

3) Automation drive

There are two factors to understand in the automation drive. One, IT firms may have been passing on profits accrued out of automation to clients. Second is the deflationary impact of automation on revenues. Brokerage Centrum Broking points out while automation aims at reducing the human effort per project through tools, algorithms, platforms, bots etc, the part of efficiency gains from automation are being passed on to clients. Citing example of Infosys, the brokerage said Infosys has been very vocal on automation to drive revenue productivity, but it is yet to translate into metrics owing to part of the benefits being passed on to clients.  On deflationary impact, Kotak Institutional Securities said automation savings built in large deals or renewals puts downward pressure on revenues. "Downward pressure on contract values has been an ongoing pattern but has accelerated in the past 12-18 months," it added.

4) Brexit and softness in financial services

The IT spends on financial services and the healthcare verticals have seen a dip lately due to clients cancelling or downsizing the contracts owing to uncertainty over Britain's decision in June to exit the European Union, with latest being the Royal Bank of Scotland (RBS) announcing that it will not pursue its plan to separate and list a new UK standalone bank, Williams Glyn (W&G), for which Infosys was a key technology partner. The UK is the second biggest market for large domestic IT firms, accounting for 25 per cent of their market. British Prime Minister Theresa May recently announced to kick off UK's exit from the 28-nation EU from the end of March 2017, but the process will take over two years. Till then, the slowness in BFSI space will weigh on the IT industry.

5) Cross-currency headwinds

Brokerage Centrum Broking said rupee depreciation, which had been cushioning the sector for the past three years, has started to reverse the trend as rupee has been relatively stable against dollar in fiscal year 2017. "Over FY13-FY16, vendors have absorbed the gains from rupee depreciation to mitigate costs headwinds (Onsite delivery expansion, shift to onsite effort led by Digital, Investments in Sales and Marketing, expanding into emerging markets), however, with the rupee starting to stabilize coupled with growth challenges, margin trajectory remains challenging ," said the brokerage.