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Why a strong Re is no threat to IT cos
Niren Shah | May 02, 2007
With the indices scaling new highs and optimism reigning over the prospects of Sensex crossing the 15,000 mark, indeed, January 2007 started with a bang.
Then came February, putting an end to all such speculations, and the mood of the market turned defensive. While auto, banks, cement and real estate grappled with the sliding markets to hold their ground, a few others like metals and oil and gas had a roller coaster ride owing to the volatility in global markets.
One sector that wrestled the storm firmly was information technology, outperforming the benchmark index consistently over the past year, and more so, the past quarter in which the broader markets corrected sharply.
The big picture still looks good. NASSCOM expects the Indian IT sector to grow to a $60 billion industry by 2010, registering a growth of around 30 per cent every year. Of this, nearly 67 per cent of revenues are derived from the United States, while revenues from Europe account for around 25 per cent, and are growing.
Now, as growth in American corporations' spending on information technology slows down, investors fear that revenues and earnings of Indian service providers will suffer too.
However, a research conducted by HSBC Global Research counters this assumption, stating that even though growth in technology spend during the last four years has been slower, at nine per cent y-o-y, compared to an average of over 13 per cent y-o-y prior to 2000, it is the semiconductor and telecom vendors who have experienced the decline.
In contrast, HSBC Global Research expects that the contribution of software and IT services to the total US IT spend, which stood at 34 per cent in 1999, would have increased to 40 per cent by 2006.
"There are no indications of a slowdown in the US for companies like Accenture. And even if there is a slowdown, it would affect the American companies more, who would see their business moving offshore," suggests an analyst.
"In addition, Indian companies have not indicated any ramp-downs from their clients," says Rajiv Mehta of IndiaInfoline.
On the flipside, it would be logical to think that even if there is a slowdown in the US, companies would look to cut down their tech spend by moving more work offshore, which should benefit Indian IT outfits.
Amid such speculation, International Data Corporation and HSBC expect the US IT spend to grow at a compounded annual rate of 4.8 per cent through 2010.
Besides, the domestic IT spend is expected to grow at the rate of 18.2 per cent per annum through 2009, according to IDC. If this is not enough, Indian IT companies are increasingly looking to make in-roads into other markets such as Europe, Middle East and Asia Pacific to accelerate growth.
Another area of concern has been the rising value of the rupee against the dollar. Since most Indian technology companies derive a large part of their revenues from the US markets, and have their billing carried out in dollar terms, an appreciating rupee could dent their earnings.
As this is being written, the rupee is scaling new highs, currently quoting at Rs 40.79 to a dollar. The central bank, too, has thus far not provided much respite in capping the climb of the rupee.
"Although the strength of the rupee against dollar appears to be continuing, we see the exchange rate stabilising at Rs 43 over the next three-four months," says Anis Sheikh, manager, risk management advisory, Mecklai Financial.
For the big five Indian IT companies, which derive about 60-65 per cent of their revenues from the US, a 1 per cent rise in the rupee usually cuts their operating margins by upto 0.5 per cent and earnings by 1-1.5 per cent.
"Most companies are hedging their receivables in advance. For instance, Infosys had taken a hedge at Rs 43.10, while Satyam was more cautious and had a hedge of Rs 42 for a dollar," says an analyst.
On the other hand, Sandip Sabharwal, chief investment officer, JM Financial Mutual Fund asserts that "the rupee should depreciate at least 3-4 per cent over the next quarter or so. Due to the sharp appreciation of the rupee we might have a scenario where margins of most IT companies may get squeezed in the short run.
"Although companies are getting price escalations in their existing contracts and new contracts are coming at a higher rate, it will not be able to compensate for the way the rupee has moved."
In FY07, IT majors hiked salaries in the range of 15-16 per cent for offshore employees, and about three-five per cent for onsite staff. Analysts believe that in the coming year too, hikes in salaries would be in line with FY07.
"For the IT industry, we expect offshore salaries to go up by 15-16 per cent on an average in 2007-08," says Rostow Ravanan, chief financial officer, Mindtree Consulting. Though it is quite possible that companies may find it difficult to pass on such cost increases to clients in case of a slowdown in the US, the industry does not seem as worried about it as of now.
"We have given a guidance for the year of 28-30 per cent revenue growth in dollar terms, and expect to maintain our margins on this growth," said Nandan Nilekani, CEO and MD, Infosys Technologies.
The strong business momentum should help companies cope with margin pressures, if any. Last fiscal, the big five not only recorded significant growth in number of clients but also grabbed a higher share of the wallet from existing clients.
"Most companies are mining their existing clients as it is more profitable considering they do not have to incur any additional sales and marketing costs to acquire clients," says Indiainfoline's Mehta.
For example, Infosys added 34 new clients last year, and the number of clients contributing over $1 million increased from 221 to 275, over FY07. Similarly, TCS added 172 new clients, with the number of clients contributing in excess of $1 million increasing from 256 at the end of FY06 to 297 in FY07.
Says S Ramadorai, CEO and MD, Tata Consultancy Services, "Sustaining delivery excellence is going to be the core of any value creation and we have to be focused on that."
Overall, analysts expect the IT biggies to deliver a revenue growth of over 30 per cent and earnings growth of over 25 per cent on an average (See table: Profitability check).
Although this may be lower than the growth achieved last year, it is a fairly impressive number in itself and in comparison to other sectors.
As the IT index outperformed the Sensex consistently over the past one year, individual stocks too, delivered decent returns. Stocks like i-flex Solutions, Rolta and Mphasis beat the IT index significantly (See table: The outperformers).
Over the past three months, however, IT stocks have taken some beating, following the negative sentiments inspired by the announcements of tax on stock options in the fiscal budget, and lack of clarity over fringe benefit tax. The appreciation of rupee has added to the gloom.
Although the outlook remains weak in the short term due to the uncertainty over the currency, the longer term appears promising for IT stocks.
"Since it will take about a month for the rupee-dollar exchange rates to stabilise, we may witness volatility over one or two quarters. In fact, if the rupee goes further below Rs 40 a dollar, we may witness some panic selling in the sector.
"The first quarter results are expected to remain weak due to the currency fallout and salary hikes. The second quarter, which is usually strong, may deliver exceptional results sequentially over the first quarter as a result," says Indiainfoline's Mehta.
"In the longer term, however, IT remains a secular growth sector with a promise to deliver value," he adds.
Further, Harit Shah of Angel Broking says, "We do not expect any movements in the sector unless any mergers or other significant events take place in individual companies. However, overall we maintain a "buy" on the sector for the longer term."
Similarly, Shriram Iyer, head - research, Edelweiss Capital says, "Our view on the sector is positive despite the strong rupee and fears of an US slowdown."
"We do not expect any slowdown in demand for Indian IT companies. Companies both in the mid- and large-cap segment should continue to grow at a healthy pace in the foreseeable future," says JM Financial Mutual Fund's Sabharwal.Currently, the biggies are trading at price-earnings multiples in the range of 22-30 times their FY07 earnings and 18-24 times their estimated FY08 earnings, which look reasonable compared to other investment opportunities in the market.