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As valuations have factored in the pessimistic market sentiment, large-cap IT stocks appear to be unduly battered now.
It has been a year since the dark clouds around the Indian information technology (IT) industry have been squaring in, and the storm in the form of a US slowdown appears to be knocking at the doors.
Last fiscal, the rupee appreciated nearly 12 per cent. Next fiscal, software companies, which have their facilities located in software technology parks or outside special economic zones (SEZs), will be brought under the tax net – a biting on net margins.
As if this were not enough, the US is facing a slowdown, which many perceive may turn into a recession. Not surprisingly, many investors have already reduced their exposure to IT stocks, and valuations of software companies are close to the lower-end of their historical price-earnings multiples.
Although it appears rational to expect IT budget cuts and a slowdown in Indian IT-companies' order flows, there is a strong view from the other side of the argument.
Fortunately, the trend emerging from the guidance of global IT companies supports the more optimistic argument that a slowdown will prompt greater outsourcing, and in turn, higher volumes for large software companies.
Examples include good results in technology consulting by Accenture, strong international growth guidance by IBM and Cognizant for 2008 of achieving 'at least 38 per cent' revenue growth.
All these signs, put together, hint at a lesser than estimated fundamental deterioration of the sector.
According to a Forrester Research market sizing forecast titled “Global IT 2008 Market Outlook”, the US market is likely to be the laggard in the purchase of IT goods and services in 2008, while the Asia-Pacific will be the pacesetter.
Forrester estimates the global IT purchases to equal $ 1.7 trillion in 2008, growing by 6 per cent, after a 12 per cent increase in 2007.
Of this spending, nearly $380 billion is likely to go toward purchases of software products and services – an area where Indian IT companies are strong.
The growth in budgets for software products is pegged at 8 per cent for 2008, down slightly from 11 per cent in 2007. The decline of the dollar is factored in, in these forecasts.
Forrester expects Asia-Pacific, and the oil exporting area of Eastern Europe, Middle East, and Africa to be the main engines of growth in IT purchases this year.
In a more recent report titled “European IT 2008 market outlook”, Forrester suggests that the European IT market will grow faster than its US counterpart, with stronger investments in software than purchases of computer and communications equipment.
The European IT spends is likely to grow 3.5 per cent in euro terms in 2008 – higher than the US growth of 2.8 per cent in dollars. Measured in dollars, this growth will be amplified further.
Now, going by the logic spelled out by economists, analysts, and company managements alike, a slowdown in the US would translate into the need to cut costs. This in turn, will fuel outsourcing, which will rather benefit the Indian software players than causing a negative impact.
Therefore, even though there may be a slowdown in overall IT spending, large Indian IT companies may not lose too much of ground, given their dominant positions in the market as well as their global presence.
Outsource IT?
“The secular offshoring trend remains intact, although there could be some challenging times in the short-term on account of the US slowdown,” says Atul Penkar, an IT fund manager at Birla Sun Life.
“However, business is likely to pick up in the medium- to long-term as cost pressures on US companies lead to more offshoring,” he adds.
Analysts sound unanimous about the volume growth holding steady in the coming year for Indian IT majors. This is likely for one more reason that the Indian software companies have a proven execution model for managing costs competitively, which will come handy for the US clients during a recession.
Besides, to counter the cost pressures, most Indian software outfits have managed price-hikes in the range of 5-7 per cent for new contracts and 1-3 per cent for renewals, over the past year due to dollar depreciation. The only risk that may now hold is that of a freeze on pricing going forward.
Value picks
Among the Indian IT pack, it is mainly the large-cap companies, which can boast of a diverse global presence and a varied client mix, which could help them weather any slowdown in demand for IT services.
Thus, Infosys, Tata Consultancy Services (TCS), Satyam, Wipro and HCL Technologies remain the top picks. After a hefty beating over the past few months, their valuations are down to the lowest range of the respective historical price-earnings multiple bands.
This means that most of the bad news surrounding the prospects of these companies has already been factored in. The companies indicate a cautious stance, in their top and bottom line guidance going forward.
However, except for TCS, no other company has mentioned any budget cut or revenue loss from their clients so far. Indications of further worsening, if any and which is not yet discounted in the share price, will perhaps be visible in the fourth quarter results of software companies by early next month.
On the banking and financial services front, there may be some risk of demand slowdown, but Indian software firms are rapidly scaling up their abilities in other verticals to keep the ball rolling. Wage inflation, on the other hand is likely to be countered by some short-term measures toward salary hikes in addition to improving utilisation levels and tackling attrition.
To sum it up all, Indian IT players may not be entirely helpless in case the US demand slows down significantly. However, mid- and small-cap software outfits are likely to be swept astray due to higher tax burden and the lack of proper risk management systems to manage foreign exchange risks.
Consequently, investors with a slightly longer term perspective and a little risk appetite can place their bets on large-cap Indian software companies to be able to reap decent rewards.
