Ride sans reason

A further correction seems due in tech shares

Information technology stocks were among the worst performers on Thursday, declining by about 1.5 per cent on an average, compared with a 0.4 per cent drop in the Nifty.

But considering the fact that they have otherwise outperformed the market in the recent past, a further correction seems due.

Without taking into account Thursday's correction, NSE's CNX IT index had risen about 16.5 per cent since the markets started rallying in May, compared with a 11 per cent rise in the Nifty.

Interestingly, the outperformance has come on the back of disappointing results announcements from industry majors, TCS and Infosys. The IT index had corrected by over 10 per cent between Infy's results announcement and end-April mainly because of the disappointment caused by the results and the near-term outlook.

What's surprising is that there has been no major positive development for IT companies since. In other words, there has been no reason for analysts to revise earnings estimates upwards.

The upshot, therefore, is that IT valuations have increased without any particular reason. The increase, since end-April, ranges from about 13 per cent for TCS to almost 19 per cent in the case of Infy.

Considering that near-term prospects are bleak for most players, the unjustified increase in valuations are a cause for concern. Wage increases for the fiscal will have its major (sequential) impact this quarter.

While most companies have said that new clients are coming at new rates, average rates are expected to be more or less stagnant as new clients account for a small share of the total pie.

Since price increases cannot be expected to offset wage pressures, profitability could be under pressure. Besides, while the rupee has been more or less flat against the dollar this quarter, it has appreciated by around 6 per cent against the euro and about 4 per cent against the pound till date this quarter.

An increasing proportion of revenues are now billed in these currencies, and there isn't any direct hedge that can be adopted to protect downside.

If any, there have been negative developments for IT companies this quarter. Their outperformance relative to the broad market, therefore, is undue.

Titan Inds

Titan Industries reported an impressive 31 per cent increase in profit before tax and exceptional items, despite a much lower 15.7 per cent increase in net sales. Operating profit rose 23 per cent to Rs 59.73 crore, despite a 130 per cent jump in other expenditure.

Savings were mainly with regards to raw material cost, and were on account of changes in inventory position. Raw material cost (including changes in stock-in trade) was down sharply to 57 per cent from 63 per cent as a percentage of sales. Operating margin, as a result, rose 120 basis points to 19. 2 per cent last quarter.

The jewellery segment turned in a sales growth of 16.6 per cent, and a 450 basis points improvement in margin. The time products division, on the other hand, reported a lower 14.5 per cent growth in sales and a mere 22 basis points increase in margin.

Nevertheless, the jewellery division accounts for just 16 per cent of total segment profit, and it was the time products division that drove overall profit growth, especially for the whole year.

For fiscal FY05, the company clocked a sales growth of 20.7 per cent. However, operating profit grew just 18.06 per cent, thanks to higher staff and advertising costs.

Besides, the company earmarked larger spends for brand building, which saw the other expenditure component jump sharply by 42 per cent. Consequently, operating margin was about 20 basis points lower at 10.9 per cent.

Nevertheless, profit before tax and exceptionals jumped 75 per cent last fiscal, thanks to a lower interest payout. Interest cost fell by 134 basis points as a percentage of sales to just 2.9 per cent. Titan has managed to employ lesser capital, despite scaling up its business.

Capital employed fell 13.6 per cent last fiscal despite the 20.7 per cent increase in turnover. With both asset turnover and profitability improving, the company's ROCE has jumped from just 12.6 per cent in FY04 to 18.7 per cent last fiscal.

This is among the main reasons the Titan stock has done well. It now gets a decent valuation of about 15 times forward earnings.

Essar Steel

Essar Steel's acquisition of Stemcor's stake in Hy-Grade Pellets (HGPL) and Steel Corporation of Gujarat (SCGL) means that it now owns a 100 per cent stake in the two companies. While HGPL will help in backward integration, the SGCL acquisition will bring in 1.2 million tonnes of cold rolling capacity into the fold of Essar Steel and enable the company move up the value chain.

As a result, the company expects cost savings as well as better realisations for its products from this development. HGPL's assets include a 3.3 million tonnes per annum pellet plant, which manufacturers iron ore pellets at Vizag. The capacity of this plant is being enhanced to 7 million tonnes.

Since HGPL will now be under the Essar fold, there would be savings of about Rs 300-350 per tonne as several local taxes would be avoided. The SGCL's acquisition will enable the company to be one of the largest producers of cold-rolled products in the domestic market. This move is expected to improve average realisations by about $150-175 per tonne.

In addition, the company is nearing the completion of a pipeline infrastructure for transporting iron ore fines from mines located in Chattisgarh to its production facilities at Vizag. Such a development would help the company eliminate incurring costly rail freight.

Essar Steel is also setting up an iron ore beneficiation plant which is expected to help improve its productivity by 3-4 per cent. These measures should help, since the company's cost of production has been higher than integrated players.

Cumulatively, these measures are estimated to result in an EPS growth of about 25-30 per cent in FY06. The Essar Steel stock was, however, down 2.2 per cent on Thursday, as the markets had already factored in benefits from the acquisition and the other cost reduction measures.

With contributions from Mobis Philipose, Shobhana Subramanian and Amriteshwar Mathur