Outlook for technology is not all that bleak. Just don't write off the sector completely
The appreciating rupee has played havoc with the valuations of IT companies. And to add to their woes, the 2010 deadline for the end of the tax holiday looms large. The net result: 30 per cent has been shaved off their valuations in the past few months.
But the outlook for the sector is not all that bleak. The bullishness on the sector emanates from a few key factors.
Tax breaks
An extension of the tax holiday beyond 2010 could be possible considering the direct and indirect contribution of the sector to the country's Gross Domestic Product.
Cash rich Stocks of companies with cash chests between $500 million and $2 billion are quoting at PEs of 15x-20x FY09E.
Great opportunity
The Indian IT industry has only scratched the surface with a 7.3 per cent share of the estimated addressable off-shoring market of $300 billion. Moreover, 77 per cent of the global IT spends are in infrastructure management and testing and validation. Since Indian players hardly have a share in this space, the next wave of off-shoring could be with them registering growth rates in excess of 70 per cent in this very space.
Good buys
Companies with the best Indian management and highest ROEs are available at PEs between 15x-20x FY 09E
Tackling Appreciating Rupee
What does bother investors is whether the appreciating rupee is likely to dent RoEs and margins significantly. Although RoEs are likely to decline, they would still be at levels that were in FY06 (Infosys' estimated RoEs for FY09 are at 40 per cent as compared to 35.3 per cent in FY06). Moreover, companies could resort to buybacks or declare higher than expected dividends to maintain RoEs. Margins would decline but would not warrant a free fall that is reflected in valuations (Infosys' margins are expected to normalise to levels prior to the rupee fall by Q4FY08E). The answer to an appreciating rupee lies in the ability of the companies to derive higher pricing from customers. Companies are altering their business models to derive higher pricing in the long term. Since these models should take another three years to have a significant impact, in the interim, the ability to derive higher billing rates from customers would be crucial to tide over the current scenario. Infosys and HCL Technologies have the ability to derive higher pricing going forward.
Companies are also developing business models that could garner higher margins. Such business models include solution based offerings, offerings based on SaaS (Software as a service) that help garner per user / per month type of revenues, outcome based revenues etc. Infosys already has 12 per cent of its revenues coming from solution-based offerings. HCL Technologies also has a number of such initiatives, and the company could rapidly scale up the proportion of revenues derived from such offerings as it operates on a small base. Wipro and Satyam have also begun deploying such models but they currently constitute a very small portion of their revenues.
Looking Up
Although IT spends could decline in the US in the event of a recession, it would only accelerate the off-shoring movement. Though the recent underperformance of IT stocks has shaved off almost 30 per cent of their market-cap, the downside risk is limited from these levels. An extension of the tax holiday would provide the much needed upside trigger.
This article was originally published on November 28, 2007.
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