Thursday, June 20, 2024

Preference for AI hits India IT stock

India’s highly regarded IT outsourcing firms are encountering a reality check as global investors shift their focus towards the artificial intelligence trend, leaving behind pricey old-economy tech stocks. In contrast to counterparts in the developed world and China, Indian software makers, including industry leader Tata Consultancy Services Ltd., have yet to make significant strides in generative AI. This, along with an uncertain outlook for client spending, could soon portray them as outdated tech investments. Deven Choksey, managing director of DRChoksey FinServ Pvt. Ltd., cautioned, “Traditional software companies’ earnings and valuations are at risk because their business models are not keeping pace with the evolving landscape.”

A BSE Ltd. index tracking Indian software stocks has recently dropped below crucial support levels, indicating a technical correction. Despite this, it remains significantly above its historical average earnings multiple following a prolonged rally in India’s equity market.

For years, India’s IT firms experienced robust growth as major global corporations outsourced extensive back-office operations to save costs, a phenomenon often referred to as getting “Bangalored.” However, revenues have started to taper off recently as overseas clients reduce spending to navigate challenging economic conditions.

Meanwhile, software and internet giants such as Microsoft Corp. and Alphabet Inc. have been pouring billions into developing their own cloud offerings and extensive language models.

“Coding is falling behind computing in the realm of tech investing,” remarked Choksey. He emphasized that Indian firms need to swiftly reinvent their business models to embrace AI and provide superior software-as-a-service solutions and infrastructure akin to Inc.’s Amazon Web Services unit.

Last month, TCS reported its slowest annual sales growth in three years. Its competitor, Infosys Ltd., issued a cautious forecast for revenue growth of 1% to 3% for the fiscal year ending in March 2025 on a constant-currency basis, neutralizing the impact of exchange-rate fluctuations.

While Indian companies and their global counterparts like Accenture Plc are expressing optimism about AI, the revenue contributions are still modest. TCS stated that its AI pipeline doubled in the last quarter to $900 million, a figure that pales in comparison to its total annual revenue of approximately $30 billion.

The volatile geopolitical landscape and uncertain macroeconomic outlook continue to impact client spending priorities. Following last quarter’s sales misses, the IT sector may face further downgrades, according to analysts at Jefferies Financial Group Inc.

“IT firms’ results fell short on the top line, and management commentary indicates a weaker growth outlook than expected,” noted analysts Akshat Agarwal and Ankur Pant in a May 7 memo. “Despite consensus estimates being slashed by up to 7% last month, we foresee additional earnings risks, constraining potential upside in share prices.”

Moreover, lofty valuations warrant caution. The BSE tech index is currently trading at 25 times forward estimated earnings, compared to pre-pandemic levels of around 18 times. This is occurring as metrics for sales and earnings growth have dipped below 2019 levels, posing challenges for the sector.

Indian software firms have lagged behind in artificial intelligence (AI) advancements. Without significant progress in this realm, they risk losing investor interest and facing threats of market share erosion.

“The trend of companies increasing AI investments while reducing non-AI expenditures is global,” observed Anurag Rana, an analyst at Bloomberg Intelligence. “We’re not seeing any signs of a turnaround.”

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