IT Sector Second Coming
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It’s a difficult task to change one’s perception, more so if it tends to be a negative one. But what makes matters worse is that such perceptions do attract many blind followers who aren’t even bothered to validate it with facts. In the stock market too there are various such perceptions or themes that keep running every day and most investors continue to follow them without any rhyme or reason. One such theme that continues to be misconstrued even today is that of the information technology (IT) sector. The reason for this is that IT hasn’t stood up to the investors’ expectations as was expected considering the brisk growth they had shown in the prior years. At one point of time it was thought that Indian bourses would no longer be driven by the brick and mortar companies but the IT companies. But the very fact that these companies failed to generate the expected exponential returns made it obvious that they would out of the investors’ ambit.
In fact we had done a detailed analysis on the sector in the year 2008 and our analysis had then showed that since 2000, despite companies such as Infosys, Wipro and Satyam’s profits growing by whopping 1,485 per cent, 994 per cent and 1,150 per cent (Satyam was one of the IT biggies then), its returns in eight years were only 40 per cent and a negative 50 per cent and 12 per cent respectively. But despite all that negativity in the sentiment we went ahead and recommend-ed the sector to the investors. And our decision was right since in spite of the turmoil we witnessed thereafter, the IT companies have performed fantastically well in the last two years. In fact our study showed that the value of Rs 100 invested in each of the scrips of Infosys, TCS, Wipro, HCL Technologies etc on April 1, 2008, today would have fetched Rs 195, Rs 197, Rs 177 and Rs 152 respectively. The best part is that these scrips leave the Sensex returns far behind as the value of Rs 100 invested in Sensex would have only fetched Rs 112 today.
Now, keeping in the mind the substantial run-up these scrips have already shown, Dalal Street Investment Journal (DSIJ) would once again want to take the odd route to understand the future potential of this sector from an investment point of view. But before we move ahead one should note the interesting scenarios in which we had taken up this sectoral analysis in 2008 and now in 2010. In 2008, factors such as the unfolding of the financial crisis, anticipation of the US economy going into recession, the BFSI segment getting impacted, pricing pressures expected to aggravate, falling contracts’ value and an appreciating rupee dominated the sector. That did not stop us in our tracks from recommending the sector as the worst had been priced in and low valuations (PE of around 20x for IT biggies) made sense.
However, today i.e in 2010 the scenario is equally opposite and this makes it even more interesting. There are certain factors such as global economies are seen recovering with the US economy leading the pack, BFSI is showing the strongest bounce-back, mega deals are being struck back-to-back, pricing pressures have stabilised though the rupee continues to strengthen and there chances that these elements will only improve going forward. Despite the run-up there still seems to be an upside potential for the scrips. Hence we believe that this is indeed a second coming for the IT sector though the bounce-back is still in the early stages.
2009: A Tale Of Two Halves
Though a macro view of the year 2009 might give you a subdued picture where spend on IT services and BPO remained flat at USD 700 billion over 2008, a deeper plunge in the half yearly data indicates a different picture altogether and hence makes 2009 a tale of two halves. The first half or the H1CY2009 was comparatively slower as the demand environment remained weak with clients delaying or even deferring their budget finalisation decisions and going ahead with value for money propositions, thereby consolidating their vendor base. They even asked for rate cuts ranging from 2-10 per cent, thus impacting the value of contracts in the first half.[PAGE BREAK]
However, with recovery setting in from Q3CY2009 with the US leading from the front, mega deals started pouring in wherein the total contract value in the second half increased by 26 per cent to USD 41.50 billion from USD 33 billion in the first half of the year. In fact, if one goes even deeper and looks at the quarterly data then the total contract value in Q4CY2009 had increased to the pre-recession levels. On a specific vertical front, this recovery was led by three sectors viz. the worst hit BFSI sector, telecom & media and the manufacturing sector. BFSI is still a major contributor to the total revenues of Indian IT companies. And it is this recovery in the second half of 2009 that led to an increase in IT spends that could match up with the 2008 levels or else the picture could have been much grimmer.
This clearly indicates that the revival has begun and is here to stay. Besides, an interesting fact showed that despite the crisis two verticals, that of the government and healthcare, showed continued increased IT spend worldwide though the other verticals during the same time witnessed a dip, which also indicate that these are recession-proof verticals and provide immense growing opportunities to grow. It should be noted that Indian IT companies are already tapping these opportunities. TCS has already bagged a project from the UK government. Besides, with increasing national priorities such as national security, immigration policy etc, IT-related spend from the government vertical will only increase in the coming period.
Volumes And Prices
If one has to sum up the revenue growth for IT companies in the first three quarters of FY10, the growth has mainly been driven through volumes. It should be noted that barring Wipro, which saw its volume shrink margin-ally in the first two quarters of FY10, TCS and Infosys showed good upward movement in volumes. Q3FY10 was the best quarter in terms of volumes wherein Infosys and TCS posted volume growth of 6 per cent each, while Wipro’s volumes increased by 4.7 per cent. Besides, what’s good to see here is that despite the subdued scenario these companies have been successful in adding new clients to their total portfolio. This indeed is a positive sign. However, what has hurt IT companies is the realisation, which remained flat throughout this fiscal, thereby leading to stunted topline growth over the last nine months of FY10.
There is hardly any improvement in pricing as clients are still hesitant about the macro scenario and hence are keeping their IT budgets flat and insisting on better value for money from IT vendors. Rostow Ravanan, CFO, Mindtree says, “For us the growth is coming from more of volume in the overall number than the price. We believe there is an increasing upside for pricing going forward. But for the next fiscal this growth would still be driven by more of volumes and less of price.” Though mega deals are back in action, indicating demand for IT services, we believe pricing in this scenario should improve, but it would take at least couple of quarters as we expect the client budgets to remain comparatively flat.
Ravishankar G, MD & CEO of Geometric, feels, “The clients cut down their budget last year and I don’t think any customer is increasing the budget significantly and they would like to maintain a flat budget. But in this flat budget they are reprioritising as to what all they want and therefore they will start getting the results of it much earlier or much easy.” A media report stated that Infosys’ 70-75 per cent of clients have finalised their bud-get for 2010 and they were flat to up 3 per cent year on year.
The Tough Get Going
Global recession has brought Indian IT face to face with ground reali-ties such as a sharp drop in business volumes, pricing cuts for new deals, renegotiation of existing deals, bud-get freeze, client bankruptcy and even anti-outsourcing sentiment, thereby pinning Indian service providers (ISPs) backs to the wall. But despite all odds the ISPs responded in the best way possible by improving efficiencies, con-trolling costs, investing in client rela-tionship etc. It is this flexibility of the Indian IT business model that helped them not only reduces the cost pres-sures for the client but also improve their own margins through improved efficiency.[PAGE BREAK]
Explains S Mahalingam, ED & CFO of TCS, “When clients were cut-ting down they didn’t get any alternate place, as India was still offering higher value than anybody else in the world. Indian companies focused more on the customer and ensured that clients get end-to-end service which means that a customer can hope to get all the services from India and we have reached that level of maturity.” Since the crisis broke in 2008, the Indian IT industry has tried to become more efficient. According to NASSCOM’s Strategic Review 2010, the industry’s utilisation rate increased by 34 basis points YoY to 74.2 per cent in December 2009, thereby indicating the effective use of the existing bench strength by the companies.
That apart, the industry was also successful in bringing down the SG&A expenses, increasing off-shoring of work from on-site and also arresting the attrition levels, thus helping in saving on hiring and training costs. To address the rising concerns on the anti-sourcing sentiment, Indian IT companies have gone ahead and are recruiting local talent in their overseas offices as it is more cost-effective rather sending Indian nationals abroad. Azim Premji, in one of the recent media interviews, explained that it helps hir-ing local talent in overseas offices as firstly it’s insurance against restric-tive visa policies which encourage local employment, positions the com-pany well for state government busi-ness and finally also helps save on visa costs and the pitfalls of H1B visa fungibility
Such strong initiatives of the Indian IT companies have helped them to not only sustain but also improve their margins. It should be noted that companies such as TCS, Infosys, Wipro etc have seen their operating margins improve every single quarter since December 2008, while on a YoY basis the margin expansion is 538 basis points, 246 basis points and 209 basis points respectively in December 2009. It should be noted that these margins have improved despite rupee appreciation, increased hiring and wage hikes and hence it is quite commendable.
‘Hiring’ On All Cylinders
One of the prime indicators of growth in the IT sector is the hiring trend that the companies show and if these numbers are something to go by then we can surely say that IT is on an uptrend. In fact though the IT biggies have over the years remained quite conservative in their estimates, the very fact they made such a huge number of offers during a lull period and even decided to go ahead and honour all of them at the beginning of FY10 was indication enough that these compa-nies anticipated good business in the pipeline. Infosys, TCS and Wipro had given offer letters to 18,000, 24,885 and 8,000 candidates respectively. In fact Infosys has steadily increased its head count for the year from 18,000 in Q1FY10 to 20,000 in Q2FY10 to an estimated 24,000 by FY10.
These companies are going to hire more aggressively as TCS is expected to add a whopping 30,000 candi-dates, while Infosys is expected to hire 24,000 people and Wipro, accord-ing to a media report, is expected to hire around 8,000 people for FY11. What makes the case even stronger is that these companies have managed to increase the utilisation levels over the last year, despite recruitments in huge numbers. Thus these companies have effectively used their bench strength. Besides, with these companies aiming at maintaining higher utilisation levels in the coming quarters with aggressive hiring numbers it is quite evident that these companies have good visibility of business in the coming fiscal.
However, Mahalingam’s opinion is, “When we talk of 30,000 peo-ple for FY11, if I remove 10,000-12,000 people as attrition, then with 18,000 people, it will give me enough to meet that kind of a demand. But if it turns to be better then obviously we will recruit more. So the current level of hiring numbers that we are talking about is not something that indicates that there is going to be runaway growth. It’s a reasonably con-servative number.”[PAGE BREAK]
Domestic Market’s Opportunity
While the Indian IT industry has been predominantly export-oriented and the sector has been more synony-mous with services to overseas markets, many tend to ignore the huge market on the domestic front. The estimated value of the domestic market is expect-ed to be a massive Rs 1,08,800 crore or USD 23.65 billion by FY10, which would account for almost 33 per cent of the total Indian IT revenues and esti-mated to grow at 8.5 per cent. Explain Ravanan, “Around 5-6 per cent of our revenues come from India and we have been focusing on the domestic market since 1999. We have Tier I customers both from the private as well as the public sector and India continues to remain an important market for us.”
We believe that the domestic market is poised at an inflection point wherein it is going through a phase character-ised by high GDP growth and high corporate growth while the govern-ment spend too is increasing briskly on various e-governance initiatives. Corporates are open to adopting best technology practices, which helps them to be more efficient and cost-effective. In fact the government’s ambitious unique identity card (UID) project is one example of how huge the domestic market can be. The project would give every citizen a UID card and a number based on the name, address, biometric details such as finger print, iris impres-sions etc. This project, which will be implemented in phases, has already got an allocation of a whopping Rs 1,900 crore in this year’s budget for the first phase.
This clearly indicates how huge an opportunity in the domestic market there can be. According to a media report, several IT firms, including Wipro, Infosys and TCS, have bid for application software develop-ment, maintenance and support ser-vices. With the brisk growth the Indian domestic market offers, IT companies cannot ignore the potential and is bound to expand its presence here. For example, companies such as Allied Digital Services and Glodyne with turnovers of over Rs 389 crore and Rs 461 crore have been more focused on India and have grown to consider-able size at quite a brisk pace. Besides, with rising disposable incomes and increased consumer spend in tech-nology-related products, the demand for IT-related products and services is bound to go up in the coming period and hence it provides the Indian IT players a unique growth opportunity in the coming period.
Recovery Driven By US
The recovery is mainly driven by the US, where the GDP data has improved quite well. However, Europe contin-ues to lag behind. US’ GDP growth recovery has been much sharper from a negative of 1.6 per cent in Q1CY2009 to 1.4 per cent in Q4CY2009, whereas Europe has shown lackadaisical recov-ery from a negative 2.5 per cent to a mere 0.1 per cent during the same peri-od. However, S Sridharan, Managing Director, Take Solutions, says, “The situation has improved but there are uncertainties still. In the US we are yet to see full recovery. The job scenario has still not shown signs of improvement which might impact the retail sector. We are cautiously optimistic.”
Our sense says that Europe recovery would pick up from the next fiscal and once that happens it could trigger another round of rally as European recovery provides more growth visibil-ity to the sector. Says Ravishankar G, “The important factor today in Europe is the fact that a country like Greece or Turkey may have its own problems and the European economy is trying to see what best it can do. Therefore that’s creating some amount of concern there. But definitely in the next couple of quarters Europe will start catch-ing up, once things get clear on the European economy front.”[PAGE BREAK]
Strengthening Rupee
However, there always have to be some concerns and this comes in the form of the appreciating rupee and the other being the non-extension of the ten-year tax holiday to the IT compa-nies under the STPI scheme. While the overall scenario seems to be improving, rupee appreciation is playing a spoil-sport for the sector. Rupee at 45.49 to a dollar continues to strengthen and over the last six months the rupee has appreciated by more than 6.6 per cent. If the rupee continues its trend, as has been the case so far, it will surely impact revenues of IT companies in the coming quarters.
To make matters worse is the end of tax benefit that will increase the tax rate for the IT companies, thus put-ting further pressure on the margins. But this is expected to hurt smaller companies more than the IT biggies. Mahalingam says, “We have been in the SEZ and also STPI and that’s why we have said that with the units going out we will come (effective tax rate) to 18-19 per cent for FY11 and 22-23 per cent by FY12.” However, we believe the current market prices are already discounting this.
Conclusion
The factors that have been discussed above clearly states that there is indeed a revival in the overall sector. The catching up of the valuations of the IT companies is a major indicator of the same. But one has also to understand that the recovery is in a very early stage and it will only gain strength as the scenario improves further and with a direct correlation that IT spend has to GDP growth, better GDP numbers will lead to increased IT spend in the coming period.
With the mega deals picking up, the demand for IT services is increasing steadily and with this demand expected to get stronger, the pricing may see an upward spiral, which augurs well for IT companies as it will add directly to their margins.
One per cent increase in pricing translates into 60-70 basis points increase in the margins. We expect Indian service providers to move up the value chain and provide services in the high margin areas of M&A, compliance and risk resulting in better profitability.
Last but not the least, the val-uations of the IT companies are still attractive, but we would stick to the front-runners. Though cur-rently Infosys, TCS and Wipro are available at PE of 27x, 34x and 35x, the premium is reflecting the higher growth investors expect. However, on a PEG ratio these companies look attractive at over 3x, 1.6x and 0.59x respectively. In fact on a year-to-date basis, Infosys, TCS and Wipro are already up by 5 per cent, 9 per cent and 4 per cent, outperforming the Sensex, which has been flat during the same period. Hence it makes sense to enter IT and grab these counters at the cur-rent level.