Reboot Or Shutdown
Last week, the BSE Sensex touched a 11-month intra-day low of 4,103 points, which is a sharp erosion in value from its February peak of 6005.85. Technology stocks have been much bigger losers. The Business Standard ICE Index is down from a peak of 449 in February to 185 points. The tech stocks, which were the erstwhile darlings of investors, have slid almost twice as fast as the rest of the market. This extreme volatility in information technology stocks has suddenly ended the party. It is almost as though the lights were switched off while everyone was celebrating.
The blood bath has also left investors pondering several critical questions. Is the party permanently over for IT? Will these stocks ever head back towards the earlier mind-boggling valuations? What, if anything, could trigger the next rally? And if one adopted a bottom-up approach, what sort of stocks could one consider for staying invested in the current market? The Smart Investor looks for answers to the above.
Growth will continue
Our conclusion is that growth will continue. Most software companies reported excellent results for the fiscal year ended March 2000. Available results of software companies indicates a topline growth of 150-160 per cent and bottomline jump of 110-120 per cent in fiscal 1999-2000. For the fiscal year ended March 1999, the industry had achieved a turnover of Rs 23,900 crore, a 46 per cent rise over FY-1998.
Most Indian software companies offer software re-engineering, maintenance services, and development of customised software, development of software products and consultancy services. While ERP (Enterprise resource planning), fixing of Y2K related problems, and Euro currency conversion offered quick and dirty growth opportunities that have subsequently ended to software companies, the internet and e-commerce is now creating new avenues for growth.
Some software companies are also focused on offering services in multimedia. The services could be offered on site (at the clients' location) or offshore (from India through satellite communication) for clients abroad. Off shore development is preferred as it is cheaper and also enables the company to avoid immigration problems. But companies are now increasingly focusing on moving up the value chain and the positioning strategy seems to be value led rather than cost led. In many cases, firms have managed to parlay the relationships forged in the Y2K era into higher value contracts from the same customers.
Adds John Band, CEO of ASK- Raymond James, " Indian software companies have more profitable revenue models. This model has not yet factored in any revenue from software requirements of dot.com companies. I expect the industry to grow at least a 50-60 per cent for next five years since corporates in the US and UK will continue to increase their IT spending for enhancing productivity. Japan, Germany and Switzerland will all be new markets for the Indian software industry." Germany may issue visas for 30,000 Indian software professionals in order to plug shortages of trained personnel in their economy. This is already becoming a political issue in Germany.
While growth will remain unhampered, analysts believe that the sector would experience seismic changes. Adds Parag Dalvi and Priya Rohira, analysts at Pranav Securities, a Mumbai-based broking house, " The shortening of application life cycles and dominance of application service providers would see dynamics in favour of outsourcing rather in-house development which would further strengthening of prospects of Indian companies. In fact, the sector should see a contractual move from time and material basis/fixed price move towards revenue sharing terms."
Analysts also point that most of the software majors are eyeing towards becoming single point total solution provider, with increased focus on information technology consulting. Hence, mergers and acquisitions would drive corporate market strategy.
Competitive advantages
The information technology sector is one of the few industries in which the country has intrinsic and sustainable competitive advantage. There is a huge market for information technology service and high potential for Indian companies to expand their share in global information technology business pie.
The sector is also substantially immune to the cyclical vagaries and constraints of the domestic economy by virtue of being export-oriented. It would be worth reiterating that the frenzied spurt in software stock prices is a result of sustained high growth of the companies. Most investors believe that these companies provide a good hedge against any political uncertainty, industrial slowdown and rupee depreciation.
Will mind-boggling valuations return?
Despite reporting excellent performances, software stocks have failed to attract investments in the last 3 months. Given that the sector was trading at average price-earnings ratios in excess of 350, this is a shock to investors. Most analysts are quick to respond that the recent correction in these stocks has been in line with over-stretched valuations are over-stretched. But one is entitled to wonder whether those mind-boggling valuations will ever be seen again.
Adds Parag Dalvi and Priya Rohira, " The valuation in the sector can be largely be attributed to strong fundamentals to extent of 60 per cent and market dynamics contributing perhaps 40 per cent. And for the immediate future, we do not expect huge price rallies as sentiment is bad and the momentum for the sector is clearly broken. With subdued market activity on the bourse for another 2-3 months, the sector may see price consolidation and any downturns should be utilised for buying strong counters."
High growth rates on year-on-year basis is the critical input that affects valuation of software companies. Stocks are discounted at the expected growth rate in the future. To maintain high valuations, IT companies will have to register triple-digit growth in the near future. Naturally the larger the base, the more difficult it is to show such performance. For instance, it is comparatively easy to grow 100 per cent when the earnings base is Rs 100 crore. But maintaining an exponential growth is tough when the firm has to earn Rs 800 crore in the fourth year and again, Rs 1600 crore in year five. The organisation has to be ramarkably good to grow so rapidly and it must identify sustainable business opportunities.
What could trigger a rally?
To trigger a big rally would require a change in mood at the Nasdaq, and also technical factors like a hike in FII limits to 40 per cent to further buoy demand for key software stocks. A possible launch of new infotech sector mutual funds could also trigger a rally due to new investment. Given that the sector is depressed it would actually be good timing to buy on the cheap.
But there are some concerns here too. A lot of mutuals have been badly burnt by the crash and and are searching for diversification in old economy stocks rather than fresh investment in IT. Since some sectors of the old economy have also signs of turnaround, fund managers could broaden their portfolios. Moreover, fund manager would focus their investments in market leaders only. On the macro front, an expected big hike in US interest rates could also inhibit inflows, which could also affect buying adversely.
Specific Stocks
Investors should restrict choices to fundamentally sound counters like Infosys, Satyam Compueter, NIIT, Hughes Software, HCL Technologies, VisualSoft, Polaris and SSI. This is because the companies have excellent business models and proven performance capabilities.
For instance, Infosys commands premium due to its global delivery model. It has a key focus is e-commerce and it is now entering into mobile commerce. The company is also broadbasing its revenues by expanding into the European markets. Satyam Computer Services has increased its revenues from application development and maintenance, and e-commerce.
Another possible pick is HCL Technologies. HCL Tech has an offshore revenue component of just 65 per cent, but the company has been able to achieve growth consistently by increasing the percentage of billable engineers.Apart from these desi blue-chips, investors should also look at companies which have technological tie-ups with global majors like IBM, Microsoft, Compaq, Cisco Systems etc. These tie-ups would enable Indian firms to leverage their brand association and they would also be the preferred outsourcing arms of their clients and associates. Investors should also look for companies with innovative abilities since the sector is sensitive to technology changes. Companies that stay ahead in the areas of technology development and adoption of new tech would command market premiums.