The IT Services sectors has been one of the best performing sectors in the rally as it started from the early part of March 2009. Subsequent to the meltdown in the global equity markets and the extremely fragile state of the financial sector in the US technology sector stocks had plummeted and some of the large cap IT names fell to valuations in the single digit ( which had not been seen since the 1990’s). Fear of loss of business, defaults of payments and a prolonged recession led to the drastic fall in stock prices.
Although the IT companies all through maintained that things were not so bad the markets were not willing to believe that. Subsequently as the stock markets have recovered and the risks of a depression have evaporated ( atleast for now) the stock prices of IT companies have recovered sharply. Prices of large cap IT companies stocks have rallied 150-200% from their March bottoms, thus outpeforming the markets sharply.
The companies have also benefited from the fact that the Indian Rupee has been weak against the US dollar and still trades at around Rs 48 to the dollar vis a vis its lows of Rs 39 to the dollar in the first quarter of 2008. As against an appreciation of just 4-5% of the rupee the Korean Won has appreciated by 25% in the same time, the Indonesian Rupiah by 25%, the Brazilian Real by a whopping 30% plus etc.
On top of that the IT companies used the slowdown to cut down on slack and rising unemployment in Western countries and a slowdown in the Indian economy both meant that wage inflation was well under control.
The other factors that have benefited the Indian IT companies has been the fact that there is a big move towards vendor consolidation globally and as a result the larger Indian IT companies are the biggest beneficiaries of the same. There is also an expectation that domestic IT spending specially from the E Governance projects of the Indian Government as well as large scale move towards getting IT enabled will benefit the technology companies.
The other benefit that the IT companies got was due to the fact that the tax breaks which were to expire at the end of the current financial year have got extended for one more year.
As a result of an improved outlook and the above mentioned factors today the valuations of a number of large cap IT companies have come back to levels of mid 20’s Price Earning ratio. The key is now to analyse whether things have improved so much so that the valuations should be such and how are other favourable factors likely to move going forward.
I believe that the Indian rupee which has been reasonable stable in a scenario where the US Dollar has continuously lost value against most currencies and the US Dollar Index is down 15% from its peak of mid March 2009 is set to begin an appreciation cycle which should average 4-5% per year over the next two years. The reasons why the rupee has not appreciated in the near term despite an inflow of USD 12 billion in portfolio flows since March,continuously falling trade deficit, strong equity fund raising, strong remittances flow etc has largely ( in my view) due to RBI keeping a tight leash on the Rupee due to the pressure on export industries which have been severely hit by the global slowdown. Also given the fact that inflation has been on a negative territory there was no incentive to let the rupee appreciate in order to control inflation.
Going forward given the fact that inflows into India are likely to remain strong and also the fact that inflation is likely to pick up over the next few months there is an increased likelihood that the RBI will let go of the rupee and we will see a steady appreciation. This will also be supported by an overall recovery in the global economy which is already leading to some sort of uptick in exports of traditional labour intensive products.
The second factor is that despite all the news flow on global recovery,the recovery in Western countries is likely to be extremely anaemic and as such one cannot expect a sharp increase in IT spending. As such overall IT spending is likely to remain subdued for some time.
The third factor is that the tax rates of most Indian IT companies will go up substantially from the year 2011-12 onwards as the extension on tax breaks runs out.
Fourthly as the Indian economy starts to recover and jobs again start getting created there will again be pressure on wages which has been absent for the last two years.
Fifthly, pricing pressure is likely to remain for some time as customers try to get the best out of their vendors. Also companies will find it difficult to rationalize costs beyond what has already been done.
Taking into account all the above factors, the current extremely positive sentiments for IT companies might get tempered as earnings growth for the next two years is unlikely to be more than 10-12% and will come under further risk if the rupee appreciates faster than expectations. Also the growing feeling that RBI might begin the tightening cycle earlier than other central banks will also be supportive for the rupee.
Under the circumstances, my guess is that the IT sector outperformance might be over for now.
“If you want to succeed you should strike out on new paths rather than travel the worn paths of accepted success”