Is the Indian IT sector losing its defensive edge gradually?

Barring the volatility of 2001 and the occasional vagaries of quarterly results, the IT sector has been largely a defensive phenomenon. Of course, nobody has forgotten the way Infosys was rampaged in April 2003 on the day of results. But these kind of frenetic movements were more the exception than the rule. In the last 2 years, most technology stocks have shown a sharp tendency to display bouts of volatility and insane price movements. What has changed in the IT sector that it is gradually losing out on its defensive edge? In fact, quite a few things!

Valuations are rich; if not daunting…

For most of the post-2003 period, IT stocks have managed to justify rich valuations on the back of consistent earnings growth. As growth starts to falter globally, the questions are being raised on the valuations front. Among the top IT companies, TCS commands a 1-year forward of 23 times, while an Infosys commands a 1-year forward of 21 times. Wipro, HCL Tech and Tech Mahindra quote at humbler valuations of 17-18 times 1-year forward. While IT stocks have averaged 17 times forward historically, it appears rich in the context of future growth guidance. This rich valuation makes this sector highly susceptible to any negative news flow.

The old order is changing; at least the margins…

For years the Indian IT sector focused on the BFSI sector and the market was large enough to accommodate all the key players without stepping on each other’s toes. Then came telecom and energy and was much later followed by manufacturing and design. Today the focus is entirely on SMAC (Social media, Mobility, Analytics and Cloud). For most of the Indian companies, SMAC still constitutes less than 4% of their revenues and that is unlikely to change in the immediate future.

The question is; are premium valuations justified for a sector which is still past perfect but not future-ready? This change has also meant that margins in the traditional BFSI, telecom and energy space is gradually shrinking. Clients are becoming more aggressive on pricing. This is more pronounced in the BFSI space post the Lehman crisis as well as the energy space after the 50% fall in crude oil prices.

A new animal called cross-currency headwinds…

Cross currency headwinds were unheard off till a few years ago. They did exist but the overall impact on the profitability of IT companies had been negligible. In the last 2 years, the US dollar has been on a secular uptrend and has strengthened against most of the global currencies including the Pound, Euro and the Yen. This has meant that there is a different level of currency movement that the Indian rupee faces versus the US dollar and a different level with respect to other currencies. But how does this matter?

Take the case of an Indian IT company like HCL Tech, which has clients across the US, Europe and Japan. When the US dollar appreciates versus the Euro, then HCL Tech’s Euro denominated revenues take a hit due to the cross currency impact. Currently, for larger companies this cross currency impact is shaving off approximately 100 basis points from margins, which is putting further stress on IT company valuations. As currencies tend to be volatile by default, this volatility tends to get transmitted to the share price performance of IT companies.

Growth is under pressure…

That is probably the million dollar issue for the Indian IT sector. NASSCOM, the representative body of IT companies has already downgraded the IT sector growth by 300 basis points from 15% to 12%. Already Infosys and TCS have guided lower growth in constant currency terms due to growth pressures. Slower growth means that these IT companies will have less room to handle cost overruns and larger benches. This adds an element of risk to the business models of IT companies and adds to the volatility.

In totality, the IT sector is in for a more subdued future. That means that valuations will be questioned at each decision point and each trigger will cause volatility. We have seen these bouts of volatility in TCS, Infosys, Tech Mahindra and Wipro. For the time being these IT stocks have lost their tag of defensive plays as they adjust to lower growth and thinner margins. Till the time the markets adjust valuations to the new reality of IT companies, this volatility will continue.

You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline

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