Despite fall in IT stocks, here’s why the tech sector outlook for 2023-25 looks good

The Nifty IT index and Omni DX (a smallcase portfolio of information technology stocks maintained by Omniscience) are down 25% and 22%, respectively, for the year, reflecting Mr. Market’s concern that a US and global recession could significantly slow the business of Indian IT and digital transformation services. These concerns are significantly overblown.

To understand Indian IT companies, the most important point to note is that more than 50% of their revenue is driven by digital transformation and related services, mostly driven by cloud computing.

Indian IT companies are partners for the top three Cloud platform providers representing a 65% market share, viz., Amazon (AWS), Microsoft (Azure) and Alphabet (Google Cloud).

These three largest Cloud players reported large growth rates in their latest quarter. Amazon reported nearly $20 billion in quarterly revenue for AWS, growing 33%. Microsoft reported more than $25 billion in quarterly revenue for Microsoft Cloud, growing 33%. Alphabet reported nearly $6 billion in quarterly revenue from Google Cloud, expanding36%.

How’s the Cloud business looking in 2023?

To quote Amazon CFO Brian Olsavsky: “AWS continues to grow at a fast pace, and we believe we are still in the early stages of enterprise and public sector adoption of the cloud. We see great opportunity to continue to make investments on behalf of AWS customers. We continue to invest thoughtfully in new infrastructure to meet capacity needs, while expanding AWS to new regions, developing new services and iterating quickly to enhance existing services.”

Amazon invested nearly $24 billion in 2021 in the AWS business and is likely to spend nearly $30-35 billion more on it. This is a total of nearly $55 to $60 billion. This is nearly 25% to 30% of the total plant, property, and equipment. This expansion indicates that the expectation is to generate around $200 billion from AWS.

Microsoft’s overall revenue guidance across businesses is as follows: We continue to expect double-digit revenue and operating income growth in both constant currency and U.S. dollars. For the next quarter Microsoft expects Intelligent Cloud to grow between 25% to 27%.

Alphabet CEO Sundar Pichai says: “On Cloud, we continue to see strong momentum, substantial market opportunity here and still feels like early stages of this transformation.”

Google Cloud CEO Thomas Kurian quotes an International Data Corporation (IDC) report showing a doubling of public cloud services spending from $500 billion in 2022 to $1 trillion in 2026, a Compound Annual Growth Rate (CAGR) of nearly 19%.

The above facts show the strength of the Cloud business in 2022 to 2026 and beyond.

Accenture, another leading Cloud services provider, grew its Cloud business by 48% for the year. It also expects to grow by nearly double digits (8%-11%) on a base of $62 billion in revenue. For comparison, the two largest Indian IT services companies are TCS, with revenue of nearly $23 billion, and Infosys, with revenue of nearly $17 billion. Both are expected to continue growing at nearly 12-15% growth rates over the next several years. Keep in mind that as the proportion of the digital and cloud business in total revenue increases the overall growth rate is expected to accelerate.

Do not forget rupee depreciation

Indian IT companies are expected to benefit significantly from the rupee’s depreciation against the dollar, which is nearly 11% for the past year. In the longer term, the rupee has depreciated by anywhere between 2.5% to 5% on a CAGR basis. This provides additional tailwinds to Indian IT companies in terms of revenue and profit.

With Indian IT companies available at earning yields ranging from 3.5% to 5.5% and growth rates in double digits over the long term, the expected total returns look quite attractive and significantly higher than the market.

One could invest directly in some IT companies but given the near oligopoly of Indian Digital Transformation Service providers and the persistent competitive advantages, it makes more sense to invest in a basket of such companies.

One could invest in Nifty IT exchange-traded funds or mutual funds, but the issue is that some of these funds could be highly concentrated. For example, NIFTY IT Index funds invest nearly 50 percent in two stocks. A smallcase basket of technology stocks is another alternative. Whichever route you choose, make sure that the basket is not concentrated around one, two or even three stocks.

Of course, remember that there are risks, including equity risks and sector-specific risks. Further, the Indian IT sector is exposed to foreign currency and country risks.

That said, a prudent allocation to the digital transformation growth vector within the equity allocation for the long term can be considered.