The lower-than-expected quarterly performance of tech companies has brought down the investor confidence in them. What could get them back on track?
It has been a sudden reversal of fortunes for tech stocks. After the steep appreciation in the last quarter, they have witnessed a sharp decline in the last couple of weeks. The benchmark BSE IT index declined by 10.5 per cent, shaving off around 50 per cent of the gains garnered in the last quarter.
With that, the sense of optimism surrounding tech stocks seems to be gradually fading, giving way to scepticism among investors. Though some shrug it off as a technical correction, many others raise serious doubts about growth prospects in the coming quarters. But most market players agree that expectations were running high, and the third quarter numbers haven't matched up to it.
"Many players had built huge positions in technology stocks due to very high expectations with regard to quarterly results. The pre-results rally led to the creation of a small bubble in technology stocks, especially at the second-rung counters," says R Sukumar, chief investment officer and senior vice-president, Franklin Templeton.
Barely a couple of months back, the market was gung-ho about tech stocks. Everyone seemed to be talking about the techs making a remarkable comeback. Analysts were elated by the robust sequential topline growth clocked by the frontline companies in the second quarter.
Infosys had reported a sequential topline growth of 15 per cent, with Wipro and Satyam also reporting decent growth of 7.4 per cent and 7.6 per cent respectively. The performance gained more importance as it came after tepid growth in the preceding 5-6 quarters, leading to speculation about the revival of the tech sector.
There were other positives like the healthy client additions and the easing of billing pressure. Top-rung companies were on a recruitment binge -- Infosys added 1,806 employees in a single quarter, about 33 per cent more than the cumulative hiring in the previous four quarters; Wipro and HCL Technologies also recruited heavily, about 753 and 521 professionals respectively.
More importantly, some companies grabbed large outsourcing orders -- the multi-million dollar deals with global majors like Lehman Brothers ($70 million), American Express ($30 million) and Pepsico ($20 million) gave credence to the vast potential that exists in the outsourcing business.
Reading between these numbers, analysts felt that the worst was perhaps over and the growth in domestic software companies could pick up considerably over the next few quarters. The fact that technology majors in the US performed better than expectations and rally in stocks on the Nasdaq too helped. But the bleak performance in Q3 triggered unwinding of positions, leading to a crash at tech counters.
What really confused the market was the over-cautious approach of some top-rung companies. Infosys, for instance, maintained the higher end of its earnings guidance at Rs 145 per share, in contrast to expectations of a 3-5 per cent increase to over Rs 150 per share for the current fiscal.
Added to this, the pressure on operating margins seen in Infosys' and Wipro's third quarter numbers and the lacklustre performance of promising mid-cap stocks like Geometric Software and Blue Star Infotech, turned sentiments gradually negative.
Given the already weak sentiments, Satyam's dismal performance sparked the sell-off at tech counters. Satyam's net profit declined sequentially by 1.26 per cent to Rs 116.7 crore. Worse still, the company expects flat growth in the fourth quarter and has downgraded its guidance for the entire fiscal. Margins are also under pressure, with the company projecting its operating margins to further decline by 150 basis points to 29 per cent in this quarter.
"The third quarter results have not been up to the mark, with the sharp pressure on operating margins being a big disappointment," says Anup Maheshwari, fund manager, DSP Merrill Lynch.
The severe pressure on margins has emerged as one of the key concerns for investors. "Instead of growth in topline, investors seems to be more concerned about the sustainability of operating margins and profitability of infotech companies now," says Feroz Kudrolli, research analyst, HDFC Securities.
And rightly so as the cost of customer acquisition has gone up considerably for the top-rung domestic companies. These companies are compelled to spend more in marketing as they now compete with global majors for acquiring large sized outsourcing orders.
The large-sized projects generally require a sufficient amount of skilled manpower in diverse technology platforms. Sometimes top-rung players have to sub-contract some of the work to other companies to fill in the gaps, which adds to the cost and affects margins. For instance, the increase in sub-contracting charges depressed Infosys' operating margins by 0.4 per cent in the third quarter. The appreciation of the rupee is another factor that could dent the bottomline.
There were other factors like the war rhetoric by US and the redemption pressure on Alliance Mutual Fund which is up for sale. These too led to the decline in the overall market. Thus, the correction is not limited to tech stocks only; the market as a whole has declined in the recent past.
So what could trigger sharp buying interest at tech counters again? At present, expectations of flat or marginal growth in IT budgets by global majors seem to be playing on the minds of investors. A recent survey by Merrill Lynch reveals that the increase in IT spending could remain lacklustre -- at about two per cent or even lower if economic conditions remain stagnant. Thus, it is obvious that only clear signs of revival in the US will bring back lost cheer to the tech sector.
Apart from this, almost everyone seems to agree that one big trigger that could renew investor interest is the acquisition of large outsourcing orders by domestic companies. "Top-rung domestic companies have been bidding for a number of large outsourcing orders in the recent past. The constant flow of large orders to domestic companies could spark broader buying interest at tech counters," says Sukumar.
But a lot will depend on the fourth quarter results and the growth guidance for the next fiscal. "The guidance by leading players will provide better visibility of growth in revenues in future," points out P V K Mohan, fund manager, IL&FS Mutual Fund. There are other technical reasons like the decision to allow futures trading in some high volume tech stocks and the pre-budget rally which could improve sentiments towards tech stocks.
In case of a rally, tech stocks are expected to appreciate more than the overall markets. "The tech sector's beta is higher than that of the overall market. Thus, it will not be surprising if tech stocks run up more sharply than benchmark indices like the Sensex or the Nifty," explains Maheshwari.
