Why you should stay invested in IT despite weak near-term outlook

The March quarter earnings turned out to be a no-show for most Indian companies, but the disappointment was most palpable in case of IT services firms. This quarter is traditionally a weak period for technology firms, but the final earnings turned out to be far weaker than the seasonally-adjusted estimates.

Not surprisingly, stocks of IT services firms are bleeding on the bourses. After outperforming the Nifty for quite some time, IT stocks have shed most of their gains. With revenue guidance for next year also muted, should investors be wary of their holdings in tech firms?

Currency plays spoilsport

The earnings disappointment was a sectorwide problem for IT services firms. The primary culprit for weak revenue numbers was the strong dollar. The sharp appreciation in the greenback against other currencies undermined the sales figures for most IT services companies. With both the pound and euro sliding against the dollar, the dollar-denominated revenues of IT firms took a hit.

Revenues from Europe have nearly doubled in the last five years for India’s top five IT companies by market value, including Infosys, Wipro and HCL Technologies, outpacing revenue growth from the US. A weaker rupee would have offset this impact when the companies converted the dollar denominated revenue into the local currency for domestic reporting.

However, with the rupee not giving up much ground, the revenues missed analyst estimates by a wide margin. These cross-currency headwinds aggravated the seasonal weakness in the March quarter. Tata Consultancy Services missed analysts’ revenue estimates for the third straight quarter.

Infosys revenue fell more than 2% sequentially. HCL Tech’s March quarter numbers came below estimates on both revenues and profit front. Wipro also disappointed. The impact was severe in case of mid-cap IT firms. Stocks of Hexaware Technologies, KPIT Technologies and MindTree were the worst hit in the sector owing to unfavourable currency movements.

Muted near-term outlook

While it would be easy to dismiss the numbers as a one-time phenomenon brought forth by currency fluctuations, the more pertinent problem facing IT firms is the weak growth outlook. The coming two quarters are likely to be particularly testing.

While Nasscom has set a target of 12-14% revenue growth for the current fiscal, it seems unlikely that IT firms will deliver. IDFC Securities has cut its FY15-FY17 earnings per share forecast by 1-5% for the top four players and 3-10% for others to build in the cross-currency headwind and weaker volume growth.

However, with US-based Cognizant Technology Solutions raising its revenue and profit forecasts for the year ending 31 December 2015, all does not seem lost. Infosys says it expects this year’s revenue to grow between 8.4%-10.4% in rupee terms. Considering it missed its guidance for 7-9% growth for the March quarter, the outlook seems optimistic.

However, analysts remain positive on the stock and repose faith in new CEO Vishal Sikka’s vision. “While we lower our growth estimates for FY16E, we remain constructive on Infosys, based on positives such as operational performance stability, steady top-client mining, volume growth and decline in attrition,” says Apurva Prasad, Analyst, Reliance Securities. Apart from Infosys, analysts continue to prefer bigger players.

“We continue to prefer tier-I IT players over tier-II, after convergence of valuation multiples in recent quarters. Our preference is for stocks with healthy prospects in next-gen technologies and with differentiated growth drivers,” says Ashish Chopra, Analyst, Motilal Oswal Securities. Infosys, Tech Mahindra and HCL Technologies are his preferred bets.

The country’s largest IT firm, TCS managed to expand its operating margins to 27.2% in the March quarter despite cross-currency headwinds and large one-time payment to staff. The margin expansion was aided by better realisations and operational efficiencies.

“TCS operating margins were in line with expectations and we expect the company to maintain margins in the stated 26%-28% band, going ahead,” reckons Dipen Shah, Head of Private Client Group Research, Kotak Securities. Wipro, however, could continue to struggle as it is bogged down by the energy and telecom verticals, where clients have scaled back spending plans. Most analysts expect weakness in stocks of mid-tier IT firms to persist.