IT stocks: Fundamentals may drive up valuations

Frontline IT stocks have galloped to new highs in the past few trading sessions. The rally in these scrips, which has beaten the volatility in the broader market, is fuelled by expectations of recovery in the global demand scenario and a benign rupee-dollar rate. Analysts believe that investors can increase their holdings in top-tier players given the possible buoyancy in overall sector fundamentals.

The scrips of the country’s top two IT exporters TCS, and Infosys have touched their all-time peaks, while those of Wipro and HCL Technologies are now trading at levels seen only during the receding dotcom wave 10 years ago. The buoyancy in these scrips resumed after the December 2009 quarterly results. In the past two months, the stocks of each of the four IT players have earned over 11% returns. The benchmark Sensex has gained 8% during the period.

Though IT stock prices are at new highs, their valuations still lag their all-time high levels. This indicates that valuations have yet to enter what experts call the overheated region.

The euphoria in the top IT scrips follows the resilient performance by these companies in the third quarter and optimistic projections by some of them. Being an export-oriented sector, IT had suffered from the slowdown in the Western economies over the past four-six quarters. Lack of new project spends and cut in existing budgets had led top IT players to report fall in revenues and profits.

The period of deceleration now seems to be over. Closing large, multi-year deals has become easier again. This is likely to bring in more business to Indian players. For instance, brokerage firm Emkay Global Financial Services expects a superior 4% dollar revenue growth for Infosys in the March quarter, much stronger than the company’s growth guidance of 1.5%. It also expects revenue to grow by 14-15% in FY11. This is after taking into consideration a moderate appreciation in the rupee against the dollar. A stronger rupee adversely impacts revenue and profitability of exporters.

Other IT companies are also expected to record stronger growth in the March 2010 quarter. The expectation of revival in growth is also reflected in the human resource data of companies. After controlling employee costs by freezing salaries and cutting headcount during the slowdown period, most top companies have offered increments and variable pay hikes. They have also stepped up hiring new talent.

Given these factors, analysts believe that there is still some steam left in the stocks of top IT firms notwithstanding their recent rally. The top four IT scrips currently trade at trailing 12-month P/Es of 23-25.