Flighty path

The rally in IT stocks seems to be ignoring the fundamental realities of the sector

IT stocks have been at the forefront of the current rally in the stock market "" BSE's IT index inched closer to a four-year high on Tuesday. In terms of fundamentals, however, there has been no dramatic improvement for the IT sector lately.

Instead things have got worse, with the rupee having appreciated by almost three per cent since September-end levels. IT companies that give a guidance on expected revenues and earnings base their estimates on rupee-dollar exchange rates that prevail at the end of each quarter. If the trend continues, EPS estimates for the year may go awry.

A stronger rupee not only impacts revenue growth in rupee terms, it also hurts profitability. This is because around 80 per cent of IT services revenues are dollar-denominated, while a big chunk of expenses are in rupees (depending on the proportion of offshore work).

Infosys has said in the past that every appreciating rupee costs it 0.5 per cent in the operating margin before accounting for gains from hedging.

What's more surprising about the recent rally in IT stocks is that it has been led by companies such as Wipro and Satyam, both of whom reported inferior results for the September quarter when compared to Infosys and TCS. To start with, their IT services business grow at a lower rate.

More importantly, for both companies, margins were set to fall in the coming quarters. Satyam admitted that operating margin would fall around 200-250 basis points in the December quarter.

In the case of Wipro, analysts expect margins to drop going forward mainly because of the non-cash charge on account of its ESOPs, higher salaries and possible losses on its outstanding forward cover positions. Regardless of this, Wipro trades at around 35 times estimated FY05 earnings.

Jobs and outsourcing

The debate on supposed jobless growth in the Indian economy points out that, despite the substantial rise in production and sales in Indian companies, job growth has not kept pace.

The reason is simple""-downsizing, rightsizing and the VRS programmes, seen in the context of higher capital intensity of modern technology, has led to job loss rather than job gains. The other side of the argument has been that there has been substantial outsourcing by the large companies.

We looked at the balance sheets of companies which have often practiced outsourcing, such as those in the automobile and FMCG sector. TELCO has seen a growth of 43 basis points to 3.07 per cent in the ratio of " purchase of finished products to net sales" from FY 2000 to FY 2004. Similarly for Bajaj Auto there was a growth of 50 basis points to 2.2 per cent while it was more or less steady at 3 per cent for Hero Honda.

Surprisingly, in the FMCG sector where outsourcing was expected to grow due to the pricing pressure, the findings were mixed. In the case of Colgate Palmolive while the purchase of finished products to net sales has grown 1170 basis points between FY 2000 and FY04 to 46.1 per cent but it has declined 600 basis points for Dabur India and 1050 basis points for HLL ( for this MNC the comparison is from CY 2000 and CY 2003).

These examples suggest that the growth of outsourcing does not seem to be very large, and it has not been sufficient to offset job losses at the larger companies.

M&M: Driving growth in auto parts

Mahindra and Mahindra has just completed its first acquisition of an auto-component player, Sar Auto Products, which is incidentally one of its own vendors. In the works are the acquisitions of a German engineering services firm and possibly a design firm in Detroit.

The acquisition gives M&M's auto components business, which it sees as a major revenue stream in the coming years, some momentum. M&M's in house auto- components platform, including four of its own subsidiaries and its engine and transmission units which are part of its farm equipment and automotive assets, together turn in a revenue of around Rs 1000 crore.

This figure, the management hopes will touch Rs 2000 crore in the next three years. More interestingly, it will supply just 50 percent of its output to M&M against 100 per cent at present.

M&M is thus cashing in on all India's inherent strengths""cheap skilled labour, design and engineering skills and R&D expertise""and marrying them with its experience in the field.

Its acquisition strategy is such that it will not completely buy out a unit but retain the existing management which it feels is an important resource as is the client list. As with any company hoping to service the global market, scale for auto-parts makers is a must.

That will spur consolidation in the sector and give companies like M&M an opportunity to team up with them, a win-win situation for both. At $6.8 bn today , the industry according to an A T Kearney study should grow at 15 per cent CAGR till 2012.

With contributions from Mobis Philipose, Amriteshwar Mathur & Shobhana Subramanian