More legs to rally in IT stocks

While ailing rupee and revival in US demand will benefit all Indian IT services companies, analysts believe Infosys, Wipro and some of the mid-caps could gain more

The BSE IT index, which scaled to its all-time high on Wednesday, has outperformed the Sensex by a mile in the past month. As against a nine per cent fall in Sensex, the BSE IT index has surged about eight per cent in this period. Of the top four IT stocks, Tata Consultancy Services (TCS) and HCL Technologies (HCL Tech) hit new all-time highs, while Infosys hit a new 52-week high on Wednesday. Wipro, too, made a new 52-week high on August 14 and is currently hovering just 1.5 per cent below its high.

A falling rupee has put the export-oriented IT sector, which gets 80-90 per cent of its revenues from foreign countries, in a sweet spot and is seen boosting the margins and earnings of the companies. More important, improving management commentary on the demand situation (driven by recovery in US and some parts of Europe) is providing high comfort.

Lastly, increasing preference of investors for IT stocks, which become a defensive bet in times of weaker Indian economic growth and a falling rupee, has added fuel. Notably, this trend of strong demand and a weak rupee is likely to sustain and benefit IT companies.

Who will gain most?
A one per cent fall in the rupee versus the dollar results in an Ebitda margin increase of 30-50 basis points for top IT companies.

Thus, though all IT companies stand to benefit from a weak rupee, some will outpace the others. The margin gains for Infosys and Wipro are expected to be more, as they are already in the process of improving their cost efficiencies (which earlier was lagging peers).

“Rupee depreciation will be a godsend for companies that are inefficient and undertaking a major cost-rationalisation measure. We assume marginally higher margin benefit for Infosys compared to the rest,” says Kawaljeet Saluja, IT analyst at Kotak Institutional Equities.

Interestingly, mid-cap companies typically outperform their larger peers in times of demand recovery, as well as a weaker rupee. This is because their margins are more correlated to revenue pick-up, due to their smaller size.

“We believe companies with the following combination are best placed. One, low margins versus the peer group. Two, low margins relative to own history, as forex support tends to exaggerate the benefits of any efficiency exercises. Three, high offshore revenue. We believe Persistent Systems and MindTree will benefit most, and MphasiS the least", says Abhiram Eleswarapu, IT analyst at BNP Paribas.

How much is priced in?
Though many analysts have already revised their margin and earnings per share (EPS) estimates for this financial year, they have assumed the rupee-dollar rate of 60-64. This means if the rupee sustains at current levels of 68 or weakens further, more earnings upgrades could be on the cards. Even if it appreciates partly from current levels, the rupee would still be weaker compared to the FY13 levels of about 54 a dollar. Also, the September quarter is seasonally a strong one for the sector, raising the possibility of better financial performance by most companies. And, with US economic growth improving, things should get better for IT companies.

“While IT services stocks have done well in the past few months, consensus upgrades and continuing the rupee weakness can provide more legs to this rally. Continuing business momentum and lack of choices in the Indian markets can further help the stocks. Concrete signs of a pick-up in discretionary spending can be the next trigger for upgrades and for stocks,” believes Anantha Narayan, IT analyst at Credit Suisse.

Further, the valuation gap between mid-cap and larger companies remains quite high. Most of the smaller companies are trading at single-digit one-year forward price/earnings ratio and can give attractive returns in the current scenario, believe analysts. However, earnings trajectory for smaller companies is relatively inconsistent. Hence, investors should stick to companies with strong medium-term visibility and good management.

The key risk for the sector remains passing of a harsh US Immigration Bill. The actual impact will vary, depending upon the strategies adopted by individual companies to execute the proposed changes. The companies can increase local hiring, move H-1B employees offshore and also increase the number of US delivery centres, though all these measures will dilute their profitability.

The other risk is to near-term valuations, which could see marginal impact if the ‘safe haven’ premium easing with the overall market sentiments improving.  

Ankita Somani, IT analyst at Angel Broking, says, “If the rupee appreciates from current levels, it will be slightly negative for Indian IT stocks. We could see some correction in the premium valuations as well. However, demand environment in key markets is better than FY13 and fairly stable. This will provide downside support to stocks.”