Getting tech savvy

As infotech companies are cash-rich, investors should focus on managements’ credibility and ability to run the business.

The information technology (IT) sector was one of the battered one on the bourses whole of last year and it continued to suffer till mid-2009. While analysts believe that the IT story is still strong, investors planning to invest in this sector need to have a long-term perspective.

BUSINESS MODEL
The export-oriented IT sector, has come a long way from being a low-cost centre for IT services to becoming business facilitators.

The $60 billion Indian IT industry employs 2.24 million people and majority of its clients come from international markets like the US, UK and Europe. Close to 60 per cent of IT sector's revenues still come from the US. In the past few years, the industry has grown at 25-30 per cent. But this has slowed due the global economic recession. Industry experts still expect a moderate growth of 13-14 per cent.

Analysts feel that investors should focus on two sets of firms. First, the large-cap or bluechips like the Tata Consultancy Services (TCS), Infosys Technologies, Wipro and HCL Technologies. And second, mid-caps such as Tech Mahindra, Patni Computer Systems and MindTree.

“Large-caps and the top mid-cap IT firms are good bets. But, as one goes down the sector pyramid, issues such as debt crop up,” pointed an analyst.

Most IT firms, especially the large ones, are cash-rich, they have good management and demand for services is still strong. But the sector has its share of negatives, too. Being export-oriented, currency fluctuation affect earning ability. Also, most of the companies are dependant on the one region, US, for business.

Key parameters for investors looking at investing in the sector are:
Cash flows: Most of the Indian IT companies are debt-free with healthy cash flow, especially the large-caps. For instance, Infosys Technologies, India's second largest IT firm, was sitting on $1.1 billion cash in FY09. Since these firms are cash rich, looking at price-to-earnings (PE) ratio is not always the correct way of evaluating them. Patni Computer is an example of this. The company has 53-54 per cent of its balance sheet in cash. But its stock is trading at 11 times PE. Analysts, hence, recommend that one should focus on the operating margins.

Price-to-Earning Ratio (PE): A year back, the top IT stocks were trading at a PE of 11-15. But with markets bouncing back, most of the top stocks are again trading at a PE of around 22. It is expected that the IT industry will grow at around 15 per cent. If that’s the case, bluechips could trade a PE of 20-22. For instance, during the economic downturn, Infosys was trading at 11-12 PE multiples, but now it has bounced back to 22 multiples.

In case of mid-cap IT firms, while they are good niche players, these firms always trade at a discount to the large-caps. This means they could trade in the range of 13-14 PE multiples.

Management Role: Most of the IT firms are cash-rich and relatively debt-free. In such a case, an investor should focus on the role of the management. “Look at how have they helped the company grow and how differently have they placed the firm,” said an analyst.

Diversified Business Or Niche Focus: When it comes to evaluating the business model, the IT sector clearly throws up few options. In case of the large-caps, one should look for the breadth of offering, deal flow, margins and management. However, in case of mid-caps, more niche and focused the company is, the better.

“If mid-caps try to get into similar offerings as that the large-cap, it will become difficult for them to compete. But a niche focus and skills driven capability in select segments will help the mid-caps to compete better,” said an analyst.

Diversification has also made IT firms look inward. This will have long-term benefits as the government of India loosens its purse strings and invests in technology.

Non-linear Growth: Post the global financial meltdown companies resorted to cost cutting. One of the obvious steps taken was increasing utilisation. This was true for the IT industry as well as for their clients. Going forward, analysts say, the non-linear focus that many IT firms have, would be growth generators.

For instance, the shift from full-time equivalent (FTE) or input-based pricing to outcome-based pricing. Earlier, IT firms charged per person per hour basis. This has changed. Client are shifting to transactions-based payment.

Non-linear growth also means, in future companies will need to move away from linking headcount growth to revenue. Investors should try and focus on the growth in volume than the number of employees a company plans to add.

Currency: One of the biggest risk for this sector is currency volatility. Close to 50 per cent of revenues for the Indian services sector is in Dollar terms. Hence, any movement in the Rupee-Dollar value impacts the IT sector. This fluctuation directly impacts the bottomline of IT companies.

Nitin Padmanabhan, analyst, Centrum Broking, sums up his outlook for the IT sector: “When the recession started the focus was on cost cutting, either by reducing manpower or capacity. The productivity gain was around 7 per cent in the last few quarters. Here onwards, any incremental growth in productivity will be by cutting people and capacity but by investing in technology and software. IT sector will witness good growth for another 5-6 years.

I would say it makes sense to invest in IT companies if you don't look at short-term gains.”