IT sector back on investors' radar

The information technology (IT) sector is returning to the reckoning of investors, with the recent rise in crude oil and metal prices raising question marks over the earnings trajectory of domestic manufacturers and retail lenders. 

Brent crude oil’s spot price has gained five per cent in the current month and is up 125 per cent from the 2016 low. Analysts say any further rise will put the rupee under pressure and translate to higher input and energy costs for domestic manufacturers and consumer goods companies. 

A weaker rupee, however, allows IT exporters such as Tata Consultancy Services, Infosys and Wipro to report higher revenue in rupee terms for every dollar of export earning, pushing their margins and profitability. This could explain the sector’s outperformance in share prices over the past fortnight. 

Combined market capitalisation of the top six IT companies rose 3.4 per cent in the past week, against a 1.1 per cent decline in the benchmark Sensex on the BSE.

Overall, the Business Standard IT (BS IT) index was up five per cent in the past one month, against a 4.7 per cent rise in the benchmark index during the period. 

The sector, however, remains a laggard in the current stock rally. The BS IT index has gained only eight per cent in this calendar year against a 25 per cent appreciation in the benchmark index. IT stocks have underperformed on a medium-term basis, too, with the BS IT index up only 2.2 per cent since the beginning of the 2015 calendar year; the benchmark is up 21 per cent.

Compared to the broader market, IT stocks are also attractively priced. For example, the top IT companies are trading at around 17 times their trailing one-month earnings on average against Sensex companies’ average price to earnings multiple of 24.5. The broader market is even more expensive, with an earnings multiple around 35. This makes IT stocks a haven if there’s a broader decline in the market. 

“A low valuation provides large downside protection for investors with exposure to the sector. In contrast, most of the popular stocks in other sectors are now trading at record high valuations, raising the risk of a sharp correction in the event of bad news flow,” says G Chokkalingam, managing director, Equinomics Research.  

In the past, IT companies suffered from poor earnings growth, compared to the rest of corporate India. “While domestic manufacturers saw earnings recovery in the past two years due to lower commodity prices, IT companies witnessed a sharp slowing in profit growth, due to a combination of poor volume growth and steady rise in operating costs,” says Chokkalingam. In the past 12 months, IT companies’ combined net profit was up 3.6 per cent against 11 per cent earnings growth for companies in sectors other than energy and financials.

Recent macroeconomic developments, however, favour IT companies over domestic manufacturers and consumer goods companies. “The recent rise in energy and metal prices is likely to push up input costs for manufacturers, resulting in lower margins and earnings growth. This will make IT companies more attractive in relative terms,” says Dhananjay Sinha, head of research, Emkay Global Financial Services. 

IT exporters are also likely to gain from a recovery in global growth. “In a sense, IT companies are global-cyclical; they do well when the world’s top companies raise IT spending in anticipation of higher economic growth,” adds Sinha. 

Historically, there is strong negative correlation between commodity prices and corporate India’s earnings growth. For example, the core operating profit (excluding other income) of domestic manufacturers (ex-energy, metals, financials and IT) was up nearly 300 basis points (bps) over the past three years to 20 per cent of net sales during the September 2017 quarter. The biggest gains were booked by metal-intensive consumer durables companies, including automobile makers. 

These saw a nearly 500 bps jump in operating margins during the period, from 10 per cent of net sales in September 2014 to 15 per cent now. In the same period, their raw material costs (as a per cent of net sales) were down by nearly 1,000 bps.

In the same period, the core operating margin of IT companies was down by nearly 150 bps, as revenue growth failed to keep pace with a steady rise in staff costs, the industry’s biggest cost head. Salaries and wages account for nearly 54 per cent of the industry’s revenue, up from 42 per cent three years ago.

The trend is likely to reverse if global economic recovery leads to faster volume and revenue growth. In the near term, margins and earnings will get a boost from a weaker rupee.