Time to consider IT?

In a new, more exhaustive version of Sector Watch, Money Today culls out information from different brokers, who are reversing their bearish stance on IT.

R Sree Ram        Print Edition: March 6, 2008

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It started off being everybody’s favourite, but information technology (IT) started losing some of its sheen last year with the BSE-IT index losing 15.6%. Some leading brokers are now, however, easing their former bearish stance. They are more open to buying Tier-I IT companies, largely because of the fall in price of IT stocks.

“A lot of the potential bad news is probably factored in the price. In absolute terms, there is unlikely to be much downside in tech stocks now. Long-term (12 months and more) investors can accumulate,” says Apurva Shah, head (research), institutional equity, Prabhudas Lilladher. Although there are looming concerns about an economic recession in the US, analysts believe that this will possibly benefit Indian companies.

Tougher times will lead to cost-cutting measures in US and European firms, leading them to outsource more work to cost-effective locations like India. “Indian IT companies have comparatively higher margins (22-30%), higher return on equity (high 30s) and return on investment capital (above 50%) and proven execution capabilities.

The demand scenario is still robust. Hence, in the long term, at least for Tier-I players, we believe that the stocks will deliver good performance,” says Harshad D Deshpande, research analyst, Religare Securities. Besides, IT companies—like most companies in the services sector—have relatively flexible cost structure that allows them to reduce cost faster and more easily than companies in the manufacturing sector.

The IT watchlist

• Corporate profits, US GDP growth rate
• Rupee appreciation
• Management comments on IT budgets
• Project cuts by clients
With most IT stocks trading at the lower band of their historical prices, brokerage houses are certain that there isn’t much of a downside left. Brokers recommend sticking to Tier-I companies, as “these companies are better equipped to deal with the current environment of appreciating currency, because they have a de-risked revenue model”, says a recent report from Karvy.

The near-term uncertainty notwithstanding, Edelweiss recommends buying TCS, Satyam Computers and Infosys. In its report of January 2008, the company noted that the markets have refrained too long from IT stocks. It added that now is a good time to buy, as there aren’t any noticeable negative cues. With most IT stocks trading at historic lows, analysts expect large-caps to deliver decent returns in a 12-month investment period.

“Despite the likely slowdown in earnings growth, the fall in valuation of IT stocks has made them attractive. Top-tier IT companies are trading at a three-year low on the basis of PEG ratio,” says Hardik Shah, research analyst, Asit C Mehta. The PEG (price/earnings to growth) ratio compares the stock price/earnings (PE ratio) to its expected earnings per share (EPS) growth rate. If the PEG ratio is equal to one, it means the stock price fully reflects the company’s EPS growth rate.

The PEG ratios of the frontline IT companies have fallen to three-year lows of below one. However, although Wipro has the lowest PEG of 0.71, it is the only stock most brokerages do not recommend buying, largely due to rising concerns about the company’s ability to hold on to margins. The best buy seems to be Satyam Computers. With improved margins and continued revenue growth of 8.1% in the third quarter of 2007-8, Satyam has an outperformer rating from Prabhudas Lilladher, AnandRathi and Enam; ICICI Direct is even more bullish, recommending a target price of Rs 550 (potential upside 57%).

An ICICI Direct report says: “Current valuations are attractive, with the stock available at 11.6 times our estimated 2008-9 EPS of Rs 30. We re-rate the stock to out performer.” Among mid-cap stocks, Rolta India seems the most attractive. Both Edelweiss and Khandwala Securities recommend buying with a potential upside of 40% (target Rs 350) in 12 months. “The company’s earnings are growing at a CAGR of 41% plus. On a PEG basis, the stock is at less than 0.30.

We believe that these valuations are attractive, considering that other IT mid-tiers are trading at PEG of 0.35-0.45 and large caps at PEG of 0.7-0.9,” says an Edelweiss report. Edelweiss adds that investors have three options. One, buy at current valuations, as “EBIT for Tier-I players is still growing at about 15-18%”. Two, wait for further bad news to push prices further to the bottom. And three, wait for the frontline IT companies to deliver the anticipated record growth numbers and then buy.

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