In a year when benchmark indices gave muted returns, technology sector was the biggest gainer of 2018 and also outperformed Nifty by a wide margin.
Strong earnings, deal pipeline and growth in BFSI segment on improved global GDP growth and US tax reforms lifted investors sentiment. And the weakening rupee also helped.
The Nifty IT index rallied nearly 24 percent in 2018 while the Nifty50 was up 3 percent and BSE Sensex rallied 6 percent.
"India IT Services coverage had a solid 2018, and the index outperformed the Sensex by 14 percent," Morgan Stanley said.
"Revenue growth surprised positively, as global GDP growth improved and US tax reforms were enacted, and as deal pipelines swelled and key verticals (e.g., BFSI, Retail) grew. A depreciating INR (versus USD), operational efficiencies, and better revenue growth helped margin expansion," it reasoned for rising earnings estimates and multiple expansion, driving sizeable stock returns in 2018.
The stocks of IT leaders saw a major jump in 2018 — TCS shot up 40 percent, Infosys 26 percent, HCL Technologies 8 percent, Wipro 5 percent, Tech Mahindra 43 percent and Mindtree 41 percent.
But 2019 is unlikely to be a good year for IT names as analysts are predicting slower global growth, especially in US and Europe. In addition to that, valuations are also high after the rally in the previous year, and also there could be pressure on margin on likely wage hike.
Morgan Stanley sees hurdles going ahead and expects global growth to moderate, with developed markets (DM) slowing, primarily driven by the US (3.6 percent YoY in 2019 versus 3.8 percent YoY in 2018).
In its view, consensus data already reflects strong revenue growth for F20, and valuations are at heady levels for some companies. The average P/E multiple for coverage at the beginning of 2018 was around 16x, with a composite revenue growth estimate of 8.6 percent YoY. Currently, the weighted average multiple is over 18x and 2019 revenue growth estimate is over 10 percent YoY.
While the focus in 2018 was on revenue growth, Morgan Stanley believes it will incrementally shift to margins in 2019, spurred by two key risks — increasing cost structures and likely appreciation in INR against the US dollar.
The rupee depreciated around 8 percent YoY in 2018.
TCS already alluded to some of these supply constraints in its December 2018 quarter call.
Morgan Stanley cut its FY20 EBIT margin estimates by 30-250bps across its coverage names largely due to potential increase in wages.
Here are 6 key reasons that led to downgrade of IT stocks in January 2019 as listed by Morgan Stanley:
Health of the global economy
Economists forecast that 2019 global growth will moderate toward trend (from 3.8 percent YoY in 2018 to 3.6 percent YoY in 2019), with developed markets (DMs) slowing, primarily driven by the US.
Tailwind from the US tax reform is also behind us, while tighter labour markets, fading fiscal stimulus (in the US), and the impact from withdrawal of monetary accommodation should slow DM growth.
What's priced in? Consensus revenue growth estimates for FY20 are at 9-10 percent YoY (versus 9.2 percent YoY for FY19) and are not necessarily building in any slowdown in IT spends due to the macro.
IT spending environment
The commentary on deal pipeline and the IT spending environment going into 2019 seems intact, with most company managements expecting the momentum to continue. While companies such as Accenture have named US-China trade tensions and Brexit as potential red flags for 2019, none of the Indian companies have yet seen this affecting their client budgets or spending intentions.
We are marginally trimming our revenue growth estimates in the base case scenario on the back of a possible slowdown in the US/Europe; however, our bear case scenario assumes that the macro issues increase and hinder IT spends; we assume F20 revenue growth for our coverage universe to be 6-7 percent YoY in our bear case versus 9-10 percent in the base case.
We saw several administrative changes on visa regulations through 2018, and companies have started talking about staffing issues in the US due to non-availability of visa-dependent workers. Further, there is a likelihood of more announcements being made by the Trump administration in early 2019 on the immigration/H-1B process (according to newspaper report).
We see these as risks to margins in 2019, as it could lead to higher onsite wage inflation and possible impact on onsite utilization.
What's priced in? Consensus is assuming margin expansion in FY20, while we are now assuming a YoY decline.
Currency forecasts assume the INR will appreciate against the USD in 2019. We have changed our F20 currency assumption from Rs 71 earlier to Rs 70 now to align with the recent trends.
Forex team forecasts Rs 68/USD by December 2019 and Rs 66/USD by December 2020, implying potential downside risk if this plays out.
We see downside risks to consensus earnings for F20-F21 and are 3-17 percent below consensus across our coverage universe.
2018 saw significant outperformance, at 14 percent. The average one year-forward P/E is at over around 18x, despite the underperformance in the past three months.Disclaimer: The above report is compiled from information available on public platforms. Moneycontrol advises users to check with certified experts before taking any investment decisions.