Will IT make a comeback?

IT giant Infosys Technologies announced its third quarter results on January 11. It registered 25.2 per cent growth in net profit and a 16.9 per cent jump in revenues, but its stock price still lost 1.38 per cent to close the day at Rs 1,580. For years, Infosys has been the unofficial bellwether of the earnings season, but that now seems to have changed. Says Apurva Shah, Head of Research, Private Client Group (PCG), Prabhudas Lilladher: “The stakes are higher for investors during this earnings season. Unexpectedly, more diversified revenues, higher fixed-price billings and no signals on a cut in IT budgets are some of the positive signals from the Infosys’ numbers. But the company’s volume growth was unimpressive and that too was driven by just a few clients. Additionally, a majority of its clients aren’t doing too well, which is a real concern.”

But is India’s IT sector heading for trouble? The rupee climbed more than 12 per cent against the dollar last year, squeezing margins of software firms. For every 1 per cent appreciation of the rupee, there is 40-60 BPS (basis points) negative impact on margins. Says Gaurav Dua, IT Analyst, Sharekhan Securities: “The steep and sudden appreciation of the rupee against the dollar played spoilsport in the first two quarters. However, the rupee has not shown any abrupt change against the dollar during the December quarter. Fortunately, in the third quarter, the dollar was largely stable and remained in the Rs 39-40 band. IT exporters are aggressively using hedging and the problem can be managed with higher billing and cost-cutting.”

The US factor

Click here to enlarge

Some analysts say that nowadays, earnings data is no longer the obvious price setter. Says Hardik Shah, Research Analyst, Asit C. Mehta Investment Intermediates: “The management’s outlook regarding IT budgets of US-based clients in the next financial year will set the tone for IT stocks going forward. Also, traditionally, the third quarter is a weak period for the industry given the holiday season.

Clients also plan for the next year at this time. Hence, growth in this quarter can be lower than that of previous quarters in dollar terms.” Agrees Apurva Shah: “Quarterly growth itself is less of a concern compared to the landmines Indian IT companies may step on in the coming months. A clearer picture is likely to emerge only later this month, when US companies start renegotiating deals or announce new contracts. In the face of a clearly slowing US economy, the sector is unlikely to show any great outperformance to the broader market.”

Besides the US issue, another worrisome factor is rising wages. Says Sandeep Shenoy, Strategist, PINC Research: “Despite the wage increase, the larger players have demonstrated ability to manage earnings growth at 70-75 per cent utilisation rate. However, the other aspect of handling wage inflation is to ensure that new recruits become billable as soon as possible.”

Silver lining

For quite a while, technology stocks have grossly underperformed the broader market due to the cynicism related to their performance.

However, analysts say near-term prospects are hazy, but the sector looks very good from a 2-3 year perspective, since current valuations are now building in very low long-term growth rates for the IT companies. Says Ajay Parmar, Head Research (Institutional Equities), Emkay Share & Stock Brokers: “I believe that the IT sector has already been beaten down and P/Es of individual companies have already contracted.

The sector may not give very good returns, but it is time to take some contra calls in select IT stocks. As far as the longterm view is concerned, the IT index will definitely offer strong returns. It has the potential to emerge as a dark horse.”

Infosys Technologies

As India’s second-largest tech and outsourcing company, Infosys wants to expand its geographical reach, especially in Europe and Asia-Pacific to cut dependence on an uncertain US market, which generates more than 60 per cent of its revenue.

It also wants to buy businesses to strengthen the array of services it can offer clients and to move up the value chain by doing higher-margin consulting work. Interestingly, in the third quarter of 2007-08, the company’s EBITDA margins was up 120 BPS (basis points).

However, one negative signal is the 25.2 per cent year-on-year volumes growth, which was the lowest in the last 15 quarters. The company’s stock— the worst performer on the benchmark BSE Sensex last year—is undervalued at the current levels, making it an attractive investment option. Look at the stock with a long-term investment horizon for good returns.

Wipro

The appreciating rupee is eating into Wipro’s margins but is making acquisitions more attractive. In August 2007, the company made the largest-ever overseas acquisition in the Indian IT space when it bought out US-based outsourcing firm Infocrossing for $600 million (Rs 2,400 crore), primarily to gain access to new markets in Europe and the US.

Recently, the company won a multi-year, Rs 2,358 crore deal to manage Aircel’s IT infrastructure, making it the first local vendor to win such a deal from a telco. Wipro registered 33-per cent year-on-year revenue growth to Rs 5,302.5 crore. Net profit in the December quarter is Rs 854 crore.

The company is looking to earn nearly one-sixth of its global IT revenues by March 2009 from the systems integration (SI) business. It currently earns 68 per cent of its revenues from Wipro Technologies, its global IT services division, and will be the first large Indian software exporter to bid for big SI contracts, competing with players such as Electronic Data Systems Corp., Accenture and Capgemini.

Wipro also has profitable presence in niche market segments of consumer products and lighting. The company’s stock price is already discounting its major plans and acquisitions, thus, making it an ideal investment for the medium term.

Tata Consultancy Services

Click here to enlarge

Recently, TCS bagged a 10-year contract from New York-based research firm, The Nielsen Company worth $1.2 billion (Rs 4,800 crore). This is the first time an Indian company has won an outsourcing order valued more than $1 billion (Rs 4,000 crore).

But a talent supply crunch, coupled with increasing wages, has forced the country’s largest software services provider to consider hiring 5,000 employees in Mexico over the next five years. It is believed that Mexican salaries are about 40-50 per cent lower than in the US, where TCS employs about 12,000 people.

For the quarter ended December 2007, TCS clocked the revenues of Rs 5,923 crore, a 22 per cent jump over the figure for the corresponding quarter last year. Net profit rose 19 per cent to Rs 1,327 crore. Says Apurva Shah: “TCS has a resilient business model and is well poised to tide over the rocky road ahead. The valuations at this stage make TCS a good investment proposition.”

HCL Technologies

HCL Technologies has a wellrounded exposure to three service lines—IT services, business process outsourcing (BPO), and remote infrastructure management (RIM) services. Says Shenoy: “I think HCL Technologies could be a surprise for the year as the restructuring and realigning of model it has undertaken over the last few quarters will stand it in good stead.

I recommend a buy on every decline in the stock.” Analysts at Emkay Research have a “buy” rating on HCL Technologies with a price target of Rs 384 by March 2009.

However, the company derives around 54 per cent of its revenues from the US. The current uncertainty relating to the economic woes of US and its impact on the IT budgets of US-based clients could impact volumes growth for HCL Technologies along with the rest of the industry.