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No way to go but up

The IT sector is showing signs of a revival but have the good times returned? We look at what lies ahead for some key stocks.

Tanvi Varma/Money Today | Print Edition: August 6, 2009

The worst is behind us,” proclaimed Azim Premji while announcing Wipro’s fourth quarter results for 2008-9. Given that the information technology sector has been through rough weather over the past months, this has been naturally greeted with some scepticism. Not all analysts and industry watchers are willing to believe Premji because they have seen the IT space in a state of flux over the past several weeks. This has largely been due to the constant rupee dollar fluctuation, exacerbated by the on-again off-again news of a resurrection of the global economy.

But is the worst really over? There’s a smidgen of hope as most IT stocks have seen a significant movement in their prices in the past few months. This is seen as a sign that prices have bottomed out. Take a look at some compelling numbers: the CNX IT Index has gained 50% compared with the 32% delivered by the Nifty, and most IT companies seem to have outperformed the index by a significant margin.

What has changed suddenly? “After witnessing a de-growth in the IT sector for the past two quarters, there is an expectation of recovery in earnings for IT stocks by the third quarter of this year,” says Anita Gandhi, head of institutional business, Arihant Capital Markets.

Historically, spending on IT services has lagged at least a couple of quarters behind the overall economic recovery. So, with the US economy showing signs of recovery, the Indian IT sector is likely to show robust growth. On an annual basis, the numbers might look flat, says Gandhi, adding that 2010-11 will see a significant growth in business due to the low base of 2009-10.

Another reason for believing that the worst is over is that market sentiment has been raised by better-than-expected earnings announced by India’s largest IT company, Infosys, for the first quarter of 2009-10. Although the company’s revenues were flat in dollar terms, Infosys surprised the market by materially outperforming its guidance of a 3.7-5.4% decline. The operating margins too improved by 50 basis points (quarter on quarter) to 34.1%, driven primarily by lower volumes decline and higher crosscurrency benefit.

“Though Infosys’s numbers were superlative this quarter, the company has maintained a muted guidance for 2009-10,” says Ajay Parmar, head of research, Emkay Share Broking. Infosys cut its 2009-10 rupee revenue growth and earnings per share (EPS) guidance by 4% each, which disappointed the market since it meant no expectation of a recovery.

But the company is known to be conservative and often tends to beat estimates, adds Parmar. Infosys remains his best pick in the sector. Similarly, other biggies such as Wipro, HCL Tech and TCS are expected to report a sequential revenue decline of 2-4% for the quarter. “It will be important to know the uplift in guidance by these companies for future direction,” adds Parmar.

Causes for the impetus
Besides the global recovery, the domestic market, which grew at a meagre 5% in the previous year compared with a 15% growth in the export market, is likely to get a boost in the future. This will be largely due to the thrust on IT inclusions in the public sector. In fact, Wipro has already signed a couple of deals this year that it bagged from the domestic sector. These are expected to contribute more than Rs 1,300 crore to the company’s 2009-10 revenues.

The government has also taken some initiatives to aid the earnings of IT companies by giving sops in the recent budget. Removal of the fringe benefit tax could lower effective tax rates by 100 basis points. The extension of the software technology park of India (STPI) tax holiday by one year is likely to increase the 2010-11 EPS for some large-caps by 3-4% as effective tax rates could be lower by 300-350 basis points than when exemptions are removed. Similarly, the removal of excise duty for packaged software will make their prices cheaper and affordable for small IT firms.

In fact, a large number of IT companies are diversifying into consulting, engineering and valueadded services, which could gain some traction with the global and domestic economic recovery. Many IT companies are also making a gradual shift towards fixed price projects, which are likely to protect their billing rates and thus arrest margin declines in the future.

Are the valuations justified?
The general view is that the valuations of several IT companies have captured the emerging upsides adequately. This is true of companies such as Wipro which is at 15.2 times 2010-11 estimates and HCL Tech which is at 9.1 times 2010-11 estimates. Analysts believe investors should hold these stocks. Other companies, such as Tech Mahindra, significantly outperformed the market over the past three months. In this case, the Satyam positives have been factored in. However, integration risks and organic growth issues still do not reflect in the price.

Gandhi feels it may be wise to wait for a price correction of at least 8-10% before buying into these stocks. She also suggests that prospective investors wait till after the next quarter to make any buying decision. That’s because they are likely to get more clarity regarding earnings and guidance. Once some light is shed on these issues, investors can expect a respectable rate of return of 15-20% from these stocks over a one-year period, she says.

Apart from corporate issues, the rain (the lack of it and then too much of it) is playing havoc with the market. That’s because it vitally affects core industries and, therefore, the economy in general. Given that the IT sector is almost entirely insulated against the vagaries of the weather, it is likely to become a good defensive bet for the future.

Key concerns
Although we are witnessing an improvement in the overall business environment, a major factor affecting the fortunes of the IT industry is the rupee dollar rate. This is mainly because 50% of the $60 billion Indian software industry is driven by exports. “The majority of IT revenues are derived in dollars. This is why one should closely watch the rupee dollar fluctuations and the hedge positions of the companies likely to be affected,” says Gandhi.

With India likely to see increased foreign investment after the formation of a stable government, the rupee could further strengthen, impacting earnings of these companies. Margins could also be under pressure in case of an increase in employee costs as the wage-bill constitutes more than 40% of the expenses of software companies.

Also, considering the fact that a third of the revenues of the Indian software sector comes from the banking, financial services and insurance (BFSI) vertical, it needs to be seen how this sector emerges. In fact, even if the US economic recovery is slow, it is unlikely to have much of an impact, as companies are more likely to outsource business to cut costs, says Gandhi.

The bottom line is that IT might not ever again see the lows that it has just risen from. It also seems only a matter of time before the industry sees a revival that will put it back in favour with investors and analysts alike.

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