The S&P BSE information technology index has underperformed the S&P BSE Sensex this year, and by a good margin. While the Sensex has gained 6.6 per cent in 2014 so far, the IT index has corrected 3.1 per cent.
Investors’ churn away from defensive sectors (IT, consumer goods and pharmaceuticals) is one reason for this fall.
Rupee depreciation and expectations of a weak show in the March quarter are other reasons.
The elections-driven rally in stock markets has led to a sharp run-up in cyclicals and reforms-oriented stocks, given the heightened expectations of a decisive mandate in the elections.
The trend is likely to change for the better. While all these factors have put IT stocks under pressure, the fundamental indicators are positive for the next two to three years.
Most analysts remain positive on the sector and believe this correction offers an attractive entry point for medium-term and long-term investors.
“We believe growth (for IT companies) will be better in FY15, given strong growth momentum in IMS/Europe and better demand in US.
We retain our overweight on the IT services sector on reasonable valuations, supported by a strong compounded annual rate of growth in earnings per share of 17 per cent over FY14-16 for tier-1 IT players. HCL Technologies is our top pick, followed by Tata Consultancy Services and Tech Mahindra,” says Ashwin Mehta of Nomura Equity Research.
Recent data from the Information Services Group (ISG) outsourcing index (measuring contracts with annual value of $5 million or more) showed a strong rise in deals awarded and annual contract value in the March quarter.
Accenture’s results resonated with this optimism, as the company’s new bookings and forecast remained upbeat.
This indicates a strong demand outlook for this financial year and echoes the optimism of large Indian IT firms such as TCS and HCL. Both these companies believe FY15 will be a better year for them as compared to FY14. Analysts second this view.
“Our channel checks indicate bookings and order closures stay healthy for Indian IT players, which we believe should translate into a reasonably healthy pace of conversion to revenues in FY15. We maintain ‘Overweight, ratings on Tech Mahindra, Infosys and HCL”, leading brokerage JPMorgan wrote in a recent note.
The latest indications are that the US immigration Bill (having strong implications on costs/margins of Indian IT companies) might not be passed in 2014.
This is a relief to the sector. Analysts believe it is unlikely a stringent version of the bill will be passed by the US.
“We believe the potential for renewed focus on comprehensive immigration reform (instead of the present piecemeal approach) could result in lower probability of the Bill becoming law this year.
This should be positive and a relief for offshore IT services. We believe approving a comprehensive immigration Bill might be much more difficult than tackling the H1B visa Bill in piecemeal fashion,” says the JPMorgan note.
Rupee: Reducing margin correlation
A stronger rupee is also a key investor concern for the sector. However, it might not necessarily put pressure on the profit margins of companies. Interestingly, IT companies have, in recent times, re-invested gains arising from a weaker rupee, resulting in limited margin boost.
Levers such as employee utilisation, cost rationalisations, onsite-offshore mix and demand push have enabled companies to sustain their margins, despite an unfavourable rupee exchange rate. When the rupee rose eight per cent (during March 2009 to March 2010) against the dollar, the top four IT companies witnessed margin expansion of 46 to 368 basis points, driven by higher utilisation rates and offshore revenues.
“Trends from four periods in the past suggest the currency impacts the sector only at the margin. However, companies have managed margins in a much tighter band than warranted by rupee moves, re-investing and pulling levers during periods of sharp currency moves,” says Surendra Goyal of Citigroup.
He believes that although the first leg of rupee appreciation always invites some knee-jerk sector rotation away from IT, the macro demand environment plays a more significant role in the medium term. Wipro and HCL are his top picks among large IT players.