Defence strategy

MARKET INSIGHT

In April 2006, it looked like smooth sailing for the IT industry. The global environment was comfortable and growth prospects excellent. Indeed, the optimistic projections and guidances for 2006-7 have been fulfilled.

About $12 billion worth of IT sector 2006-07 results have come in and the performance has been good. TCS, Infosys, Wipro and Satyam have all delivered strong revenue growth and excellent profit growth.

However, the CNX-IT has just about outpaced the broader market. The Nifty has risen 17.5 per cent since April 1, 2006, and the CNX-IT has moved up 20.5 per cent.

This seems a bit puzzling. IT features tried-and-tested businesses that credibly deliver on high projections. Surely they should have outdone the market by a larger margin?

Indeed, IT valuations have declined despite the price rise because EPS growth has outpaced capital appreciation. In April 2006, the CNX-IT was valued at an average P/E of 47.5 and it is now trading at a P/E of 31. In contrast, the Nifty, which was held at an average P/E of 20.7 in April 2006, is still at an average P/E of 20. So far, 2006-07 EPS growth for the broad market (inclusive of IT pivotals) has just kept pace with price appreciation.

In 2006-07, traders and fund managers alike were too busy chasing realty stocks at triple-digit P/Es to bother with boring, predictable IT.

In mid-2006, analysts were suggesting in all seriousness that investors were wary of weaker 2007-08 growth in the tech sector!

But in the past two weeks, the CNX-IT has shot up 6 per cent. It has been the primary driver for the Nifty (also up 6 per cent). Has there been a re-rating? Have prospects improved dramatically for the IT industry in 2007-08? No, guidances and projections still suggest slowdowns in the current fiscal.

The global macro environment is less favourable than in April 2006. The rupee has appreciated a lot against dollar and the bulk of IT earnings are in dollar.

What's more, everyone agrees that there will be a downturn in the US by end-2007. That will make it more difficult for IT/ ITES to generate big-time growth. Also a talent-crunch has compelled increased spending on recruiting and retaining talent, further squeezing margins.

So, is the market now looking two fiscals ahead to a likely recovery in 2008-09?

I think that is about as far-fetched as the chance that the market was looking two years ahead in April 2006 when it was lukewarm about tech stocks. Most traders do not look beyond the current week and most fund managers do not look beyond the current fiscal.

More likely, the virtues of boring but predictable growth have suddenly become more highly-rated. The realty sector has gone through a deep correction which could continue; the SEZ story will be discounted more conservatively after Nandigram and the recent restrictions on size, acquisition methods, rehab norms and land-use for "non-processing".

The rate hikes of the past 6 months have started to bite in terms of volume growth in auto-sales and in home loans. The hope of immediate power sector reforms has receded with the can of worms opened by the Sasan ultra-mega project.

In that light, even the reduced guidances and projections for IT/ ITES in 2007-08 seem attractive. There is a high degree of confidence that those guidances will be fulfilled. IT is cyclical "� but it is being viewed as a defensive haven at this instant. It is after all, immune to rupee rate hikes except insofar as those affect forex rates.

The top-rated IT companies also began diversifying into non-dollar markets and value-added businesses quite some time ago. Euro-denominated revenues and margins in the consultancy business are considerably higher than for scut-work.

Even much-derided BPO revenues are increasingly coming from financial back-office work and upper-end services rather than voice helplines. The big boys can hope to maintain stable margins at the least in 2007-08.

The last but perhaps most important point is valuations. Infosys suggests that it can deliver 22-23 per cent EPS growth next financial year.

The market thinks it may better that considerably. TCS is generally reckoned capable of delivering close to 30 per cent EPS growth. Both the stocks are trading at roughly 24 times their 2007-08 EPS. And that is reasonable value for money.