Tech stocks rise despite concern over weak quarter

The continued rise in technology stocks despite their tepid first quarter performance is beginning to make some market players nervous.

Even though evidence suggests a slowdown in growth momentum and rising margin pressures, price earnings multiples of some top tier players are around the highest in two years.

The performance by Indian top tier players for the April-June quarter did little to boost confidence in the sector.

While Infosys Technologies and Tata Consultancy Services reported tepid volume growth, some others, which saw robust rise in volumes, disappointed with their margins. Also, employee utilisation rates in the last four quarters have been lower from a year ago.

With volume growth remaining lacklustre, there are now concerns that utilisation rates may trend lower.

Most players had hired aggressively in 2004-05 (April-March) in anticipation of strong demand and some analysts estimate that a percentage point drop in utilisation rates could impact earnings before interest depreciation, taxes, and amortisation margins by 20-25 basis points.

Typically, significant ramp-ups by top clients in 2004-05 have been key growth drivers for Indian vendors. An analyst with a domestic brokerage noted that top 10 clients accounted for a quarter of incremental revenues in 2004-05 (April-March). In the first quarter of 2005-06, their contribution to incremental revenues dropped to 2.4 per cent.

The consolidated quarter-on-quarter growth in top 10 clients for Infosys, Wipro, and Satyam put together for the first quarter was a mere 0.4 per cent, compared with 2.2 per cent, 12 per cent, (-)0.2%, and 6.3 per cent, respectively, for the four quarters of 2004-05, he said.

Also, some accounts have ramped down with at least Wipro reporting a drop in the number of its $3 million-plus accounts.

Figures show that consolidated quarter-on-quarter growth for Infosys, Wipro, and Satyam from Europe for the first quarter was at 8 per cent but sharply lower than the 18 per cent reported a year ago.

To add to these worries, growth in telecom and manufacturing verticals have been disappointing for some quarters now. The traditional services lines of application development and maintenance, which accounts for 62 per cent of the top four vendors, have remained sluggish in the last three quarters.

Analysts note that a sluggish growth in these service lines could lead to increasing price competition among players which in turn could force a rise in selling expenses.

During the last two years, top players expanded their margins mainly by cutting down on their sales, general, and administrative expenses. The consolidated EBITDA margins for the big four expanded to 28.8 per cent in the first quarter 2005-06 from 27 per cent in the corresponding period of 2004-05. During the same period, SGA expenses as a proportion of revenues dropped by 220 basis points.

But analysts note that costs could rise, as companies invest further in business development. Rising wages are also likely to boost expenses. These could lead to a decline in margins. Consolidated EBITDA margins dropped 80 basis points on a quarter-on-quarter basis for the first quarter.

The operational performance of software firms may have offered little cheer so far this year but stocks have continued to rise. For example, since the beginning of the calendar year, Infosys, Satyam, HCL Technologies, and i-flex solutions, have jumped approximately 8 per cent, 23 per cent, 22 per cent, and 50 per cent, respectively.

During the same period, BSE Sensex and Nifty have gained 14.7 per cent and 10.3 per cent, respectively. The NSE IT index has jumped 28 per cent during this period.

Infosys, Satyam, and HCL Technologies are trading at forward PE ratios of 25, 18, and 18 times, respectively. These are close to their highest levels in two years.

Many analysts believe that stock prices have been fuelled by the burgeoning flow of foreign portfolio investment into the local market.

The net FII investment in July was $1.9 billion, the highest-ever in a single month.

"We suspect the biggest of these factors is the inflow of foreign portfolio investment into the Indian markets," according to an IT analyst with a local brokerage.

"We believe it is this huge liquidity that is de-coupling the financial performance of companies with their stock prices."

Foreign hand or not, the sector may be in for a series of downgrades if the second quarter does little to change the tide in the operational performance.