The IT sector has been one of the standout performers over the past year, with the Nifty IT index more than doubling investor wealth and giving a 102.5 per cent return. The reason investors have been loading up on the IT sector is the revenue visibility it offers. After a gap of about eight years, the sector is expected to get back on the double-digit trajectory in FY22. Besides, the Street is rewarding IT companies on expectations of consistent margin performance, strong free cash flows, and prudent capital allocation.
Given that these attributes are typically associated with consumer companies, investors are asking whether the sharp valuation premium of fast-moving consumer goods or FMCG companies remain and will the IT sector see a further rerating.
While the IT sector has been rerated over the past year with valuations up 82 per cent to about 26x one-year forward valuations, analysts believe there is still scope for further rerating. Suyog Kulkarni of Reliance Research says: “While double-digit growth in FY22 is a given, the commentary by global majors on IT spends and deal values, the increasing share of the higher growth digital segment, and the compulsory nature of spends points to a multi-year growth story for Indian IT majors. Given the possibility that the recent trend of record-breaking deal values can sustain, there is no reason why the IT sector (top four IT majors) should not see a further rerating.”
The factors responsible for the FMCG sector’s valuation premium over the IT sector were revenue visibility reflected in higher revenue growth, steady margins, and earnings acceleration. With IT unable to come out of the single-digit growth run rate, the valuation premium of the FMCG sector had expanded in the past four years. Profit growth for consumer companies was led by volume growth on the back of strong rural demand and muted raw material costs. Some of the triggers are missing this time around.
Crude oil, palm oil, copra, and a slew of crude oil derivatives have all risen sharply over the year-ago levels. Until February, the entire commodity raw material basket (consumer sector) had risen 13 per cent as compared to the year-ago period, say analysts at Motilal Oswal Research.
Though companies have taken price hikes and curbed certain discretionary spends, the rise in advertising spends and brand investments may offset the same. While revenue growth is expected to be steady, margins are likely to be under pressure. On the other hand, an increasing proportion of the higher-margin digital segment and hybrid model of work for employees are some of the levers for the IT segment.
This can put pressure on valuations of consumer companies, as well as the premium they command over other defensive sectors, such as information technology.
Dhirendra Tiwari and Pankaj Chhaochharia of Antique Stock Broking say: “Over the next two years, FMCG and IT services are expected to deliver similar earnings growth. While the IT services sector is riding the ‘digitisation’ wave, thus providing further scope for earning growth, the FMCG sector’s earnings may get negatively impacted by higher commodity prices. Accordingly, we believe the valuation differential between the two key ‘defensive’ sectors will meaningfully narrow over the next two years.”
Excluding ITC, the FMCG index at 50x one-year forward valuations is trading at twice the valuation of the IT index or at a 100 per cent premium. Analysts at Antique Stock Broking believe the same should be in the range of 15-50 per cent. Business Standard