Crash in store

Overvalued IT stocks leave room for disappointment over results

NSE's CNX IT index gained 1.1 per cent on Monday, ahead of Infosys' and Tata Consultancy Services' results announcement on Tuesday.

The fact that this happened on a day when the Nifty fell by 0.3 per cent suggests that the markets expect good numbers for the September quarter.

Good numbers for IT normally refers to growth upwards of 8 per cent on a quarter-on-quarter (sequential) basis. The big three - TCS, Infosys and Wipro - are expected to grow both revenues and profits between 7 and 10 per cent sequentially, which is the reason for the enthusiasm on the street.

But it looks like the markets have already forgotten Infy's negative surprises in the previous two quarters. Not that Infy would come out with a negative surprise even in the September quarter, but the fact that its performance was lacklustre in the June quarter simply means that achieving analysts' aggressive earnings estimates for FY06 is tougher.

To achieve the consensus EPS estimate of Rs 92, Infy would have to grow earnings by 11 per cent sequentially for three quarters in a row. (Infy's guidance puts the FY06 EPS at Rs 86, at an average sequential growth of 6 per cent).

Even if one were to assume that Infy achieves the consensus target, it still trades at 28.4 times forward earnings. On trailing 12-month earnings till June 2005, the stock trades at about 35 times, higher than the 25 to 30 per cent earnings growth expected over the next couple of years.

TCS's forward valuations seem more reasonable at 24 times estimated FY06 earnings, but then the company's year-on-year growth rates in the recent past have been lower than that of Infy's.

Coming back to September quarter results, it is expected that large IT companies should report sequential revenue growth between 7 and 10 per cent, driven by volumes.

Since salary hikes were absorbed largely in the June quarter, margins should see some improvement, especially since the movement of the rupee was favourable for IT exporters.

The depreciation in the rupee last quarter should result in translation gains (leading to higher other income), which is expected to result in higher net profit growth. TCS, however, could see pressure on margins given that its global salaries were re-aligned last quarter.

Given that trailing valuations of all top IT players are in excess of 30 times, it's important to keep an eye of year-on-year growth rates. The markets, however, would largely be looking at sequential growth rates, and there would be a sell-off if growth rates are below the expected level of seven to ten per cent. Besides, analysts are also expecting companies such as Infosys and Satyam to raise their guidance estimates. While announcing results last quarter, the companies had indicated that recruitment numbers in the September quarter as well as for the rest of the year would be aggressive. Any disappointments on these two fronts could also result in stock price corrections.

The CNX IT index has risen about 20 per cent in the past quarter, despite lacklustre results in the June quarter by the sector as a whole.

Although the increase in IT stock prices in the past quarter was largely in line with the market, in terms of fundamentals, the increase is hardly justifiable. The high valuations of top IT companies leave ample room for disappointment when results are announced.

FMCG Industry

With the agricultural sector expected to grow by 3 per cent in FY06, FMCG companies can look forward to some good times ahead.

June quarter numbers were already impressive - the top eight listed FMCG companies grew sales by 17 per cent, while their earnings before interest, depreciation and tax rose 18 per cent and the net profit grew 25 per cent, the highest in six years. Besides, spends on advertising grew in double digits for almost all companies.

For the September quarter, however, the numbers may not be as impressive. For one, volume growth could have suffered because of floods in some states. Also, while most input prices remained stable during the quarter, the increase in diesel prices in September would have added to costs.

Nevertheless, fiscal sops for units located in backward areas should help mitigate higher input prices, and margins could be sustained.

Going forward, analysts believe that with disposable incomes growing, consumers are beginning to upgrade. This is good news for companies, since they may be able to take price increases in select categories.

The turnaround in the sector has been appreciated by the market "" the FMCG index has been one of the best-performing sector indices, of late. Stocks now trade between 16 and 29 times estimated FY06 numbers, and much of the near-term upside appears to be priced in.

Contribution from and Shobhana Subramanian