BackUS leading indicators portend gloom for Indian IT industry
As far as IT stocks go, investors appear to be getting carried away with the widening gap in valuations vis-a-vis those of pharma and consumer packaged goods stocks
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Information technology (IT) stocks have done fairly well this month, rising marginally while the broader markets continued to decline. Since the begining of 2015, the National Stock Exchange’s CNX IT index has outperformed the benchmark Nifty by 10.6%.
Economic data from the US suggests things might go from bad to worse for Indian software services firms. For starters, the US manufacturing purchasing managers’ index (PMI) fell to a two-year low in August. The index has fallen from 57.6 in November last year to 51.1 in August, and the sharp decline is not reflected in the share prices.
Analysts at Nomura Financial Advisory and Securities (India) Pvt. Ltd point out that US manufacturing PMI is reflected in the demand for IT services from US clients with a lag of two to three quarters, citing data since 2006. Another important US economic data point Nomura’s analysts look at is the trend in private job additions. The monthly average so far this year is 20% lower than the average for 2014. Besides, they point out that the financial performance of key industries such as banking and financial services and retail deteriorated in the June quarter; and in the case of other industries such as consumer, chemicals, oil and gas and automobiles, performance has worsened over the past three to four quarters. Again, this is expected to reflect in the demand for IT services within the next few quarters.
Already, the industry’s growth has decelerated considerably. The top five IT services companies listed in India reported cumulative revenue growth minus that from acquisitions of a mere 5.9% in the June quarter. Even after adding back about four percentage points to these growth rates to adjust for cross-currency headwind, it’s alarming that growth has dropped to single-digit levels.
Some of this has to do with the fact that these firms have lagged behind in building digital capabilities. Cognizant Technology Solutions Corp., which has been ahead of the curve on this front, reported a 15.5% growth in organic revenue last quarter (www.mintne.ws/1L7WvvM).
If the leading indicators from the US economy are accurate, growth can be expected to slip further in the coming quarters.
Of course, the recent depreciation in the rupee provides some relief, but will hardly be enough to offset the pressure on profits from a drop in revenue growth.
To make matters worse, some Indian companies have been aggressive on hiring, which can backfire if demand doesn’t improve.
As far as IT stocks go, investors appear to be getting carried away with the widening gap in valuations vis-a-vis those of pharma and consumer packaged goods stocks. Nomura’s analysts say, citing Bloomberg one-year estimated price-to-earnings data, that IT stocks trade at a 30% and a 44% discount to pharma and packaged goods stocks, respectively, which is higher than the historical average of 23% and 34%, respectively.
A narrower discount makes sense if IT stocks are seen as a defensive bet. However, in the current global economic scenario, it’ll be naive to come to that conclusion. Perhaps, as always, investors will wake up after the quarterly results are announced.
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