Jefferies’ latest report casts doubt on the expected improvement in EBIT margins for IT companies in FY25. The consensus expectation is for an increase of 80 basis points (bps) year-on-year (YoY), reaching 20.3% for the sector. However, despite the optimism of a significant improvement of 380 bps. (240 bps adjusted for one-time items) in Tech Mahindra (NS:) (TechM), forecasts for other IT companies suggest only modest growth of 20-80 points. Jeffries highlights several issues that could hamper the expected growth of these earnings, creating potential risks to earnings.
The report highlights an alarming trend in the employee demographics of leading IT companies such as Tata Consulting Services (NS:) and Infosys (NS:). The share of employees under 30 years of age has fallen to its lowest level in five years. This shift towards an older workforce, coupled with near-peak utilization levels, suggests a less flexible and more costly workforce mix. As demand remains sluggish, it may be difficult for these companies to reverse the trend quickly. Consequently, a deteriorating employee pyramid and high utilization rates may hinder profitability growth.
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Jefferies has seen significant reductions in subcontracting costs across the sector. These costs are now at their lowest level since FY15 at 9.1% of sales, down 230 basis points from their peak in FY22. The reduction reflects efforts by IT companies to cut costs amid weak demand. However, since subcontracting has already been reduced to a minimum, there is little room for further reductions. The exceptions are Infosys and TechM, where subcontracting costs remain relatively high but are still close to the five-year minimum.
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The report also highlights the valuation challenges of giants like TCS. According to InvestingPro’s fair value estimate, TCS is priced at INR 3,439 per share and its current market price (CMP) is INR 3,893, indicating it is overvalued by 11.7%. This discrepancy poses a risk to investors, suggesting the stock may be overvalued.
However, using fair value measures that adapt to changes in the market can help investors make timely decisions. Once the fair value of a stock rises above the CMP, investors may be wise to consider taking profits and reallocating their investments to companies with a more favorable valuation gap.
Jefferies’ analysis suggests that the expected improvement in IT companies’ earnings in FY25 may not materialize as expected. Factors such as an aging workforce, near-peak utilization and already minimized subcontracting costs pose significant barriers to improving profitability. Moreover, the valuation concerns raised by InvestingPro, especially regarding large players like TCS, add another layer of risk for investors. Obtaining information through fair value estimates can help address these challenges and optimize investment strategies.
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