Holy trinity playing out for IT companies

Earnings upgrades likely for software services companies as growth revives in US and IT spends pick up

The BSE IT Index has been on a roll over the last three months. IT stocks have given 33% returns to investors over the last three months as all variables have turned positive for the sector.

Analysts are calling this the holy trinity of growth, currency and demand. Since the Lehman crisis broke in September 2008, IT spends by American corporations have been volatile.

Consensus earnings estimates of S&P500 indicate that revenue growth and profitability has never been better in the last four years. Analysts claim that almost all companies are seeing a pick-up in deal signing.

This implies that volume growth should pick up for most players in the sector over the coming few quarters. Espirito Santo Securities expects consensus estimates of IT companies’ dollar revenue growth to be increased.

So far, Indian software service providers have got a boost to their margins thanks to the rupee’s depreciation. But now the rupee’s fall will give Indian companies a lever to fight for volumes.

Macquarie Capital, which has upgraded the sector to outperform, says: “After two years of poor revenue growth in the sector we are getting more comfortable with the USD top-line growth of the sector.”

But this is the first time in two years at least that actual demand environment is showing improvement. Also, so far the market has had muted expectations from players like Wipro and Infosys, which have seen growth slowdown over the last few years.

Both Wipro and Infosys have realigned their cost structures to suit the new reality of slower growth. Consequently, when growth returns, both these companies will report higher margins.

With demand picking up and rupee staying at current levels, consensus earnings estimates for these two companies would also inch up. Analysts expect Infosys to increase its FY14 dollar revenue growth guidance. Espirito Santo expects Wipro to guide to 1.5-3.5% revenue growth for Q3 FY14.

However, a weaker currency comes with its own problems. While it is good for incumbents, persistent weakness in the currency would result in competitive intensity returning to the sector and this would put pressure on wages. With the entry of new players, the pace of commoditization would also increase rapidly.