The Bull Case for IT Services
Despite a challenging period where the Nifty IT index has underperformed, Sandip Agarwal of Sowilo Investment Managers believes the worst is over for traditional IT services companies. His bullish stance is rooted in several factors. Firstly, he argues
that the market has already priced in the negative impacts of artificial intelligence, which he estimates will cause a manageable 3-4% annual revenue deflation over several years, not the catastrophic decline some had feared. According to Agarwal, once you adjust for this AI-led pricing reset, the underlying demand shows that many companies are effectively growing at a much healthier rate than their reported revenues suggest. He believes this pricing shock will be absorbed within the next couple of quarters, paving the way for a clearer growth trajectory. Furthermore, a depreciating rupee is expected to provide a significant tailwind, potentially adding to earnings per share (EPS) growth. After a period of client indecision, Agarwal sees a return to more normal decision-making on IT budgets, suggesting a stabilization and future recovery in deal conversions.
Why the Caution on Engineering R&D?
While Agarwal is optimistic about IT services, he strikes a decidedly cautious tone on the Engineering Research and Development (ER&D) sector, also known as product engineering services. His primary concern is that ER&D companies are much more exposed to the disruptive and deflationary pressures of AI. He argues that the nature of engineering and design work makes it more susceptible to automation-led efficiency gains, which can compress revenue and billable hours more severely than in traditional IT. Another key factor is valuation. Agarwal has repeatedly stated that ER&D companies are trading at multiples that are four to five times higher than IT services firms, a premium he feels is unjustified given the risks. While acknowledging that the ER&D space has the potential for faster long-term growth, he believes the current valuations do not adequately reflect the potential for a significant correction, suggesting the sector could fall another 20% before it becomes attractive. He also points to the fact that some ER&D firms benefited from market share gains following geopolitical shifts like the war in Ukraine, a benefit that could reverse in the future.
A Tale of Two Tech Demands
The core of Agarwal's thesis lies in the fundamental differences between the demand drivers for IT services and ER&D. Traditional IT services—covering application maintenance, cloud migration, and infrastructure management—are often seen as less discretionary. Even in a tough economic climate, companies need to keep their core systems running. The new wave of AI is creating demand for integration, data management, and cybersecurity, which plays to the strengths of India's large IT services firms. In contrast, ER&D services are often tied to new product development and innovation cycles, which are more discretionary. When global enterprises face macroeconomic uncertainty, R&D budgets are often among the first to be scrutinized or reduced. While the long-term outlook for ER&D in India is strong, driven by trends like software-defined vehicles and industrial automation, the near-term is clouded by this sensitivity to client spending cuts. Agarwal's analysis separates the resilient, annuity-like business of IT services from the more cyclical, project-based nature of ER&D.
Navigating the Investment Landscape
For investors, Agarwal’s analysis provides a clear, albeit nuanced, roadmap. He suggests that the IT index as a whole is an attractive investment, predicting potential returns of 13-14% annually for the next two years, driven by modest 6-7% dollar revenue growth combined with currency benefits. However, he strongly advises against investing in ER&D companies at their current high valuations, urging investors to wait for a significant price correction. His preference is for traditional IT services companies, especially well-managed large-caps and select small and mid-size firms that are not heavily exposed to the ER&D segment and are trading at reasonable price-to-earnings-growth (PEG) ratios. He argues that while ER&D may offer higher growth, the risk-reward profile is currently unfavorable. The strategy he advocates is to focus on valuation discipline and avoid chasing high-growth narratives in an expensive segment, instead favoring the steady, undervalued potential of the traditional IT services backbone.
