Investors in information technology (IT) companies have had a roller-coaster ride in the past four months. First, it was Donald Trump’s election as US president and the possibility that visa rules would be tightened; now, it’s the appreciating rupee. But at the end of the day, IT stocks haven’t done all that badly. In fact, the Nifty IT index has risen nearly 8% since the US election results were announced, slightly better than the 7% gain in the Nifty 50 index.
What gives? While restrictions on visas can hurt Indian IT firms, most analysts expect the impact to be limited to margins, as opposed to affecting the ability to win orders and grow revenue. Besides, the rhetoric has been toned down in recent weeks, and investors seem to be breathing easy. And in the midst of all the gloom, a number of IT companies have decided to return cash to shareholders through large buybacks. This will improve return ratios, and eventually result in better valuations.
But the biggest reason IT stocks have done relatively well in the past four months is that investors find valuations reasonable vis-à-vis the rest of the market, which is fairly heated up. “We believe earnings expectations have moderated for the sector and valuations are cheap given strong cash generation. We note that some large-caps are trading at 5-7% earnings yield, leaving room for capital allocation-led upsides for shareholders,” analysts at Religare Institutional Research wrote in a note to clients. Tata Consultancy Services Ltd (TCS), the priciest IT stock, trades at 17.5 times one-year forward earnings, lower than the Nifty’s valuation of around 18 times forward earnings, based on Kotak Institutional Equities’ estimates.
While there is little doubt that revenue growth has slowed, these companies still generate high amounts of cash, and have takers when valuations fall below a certain threshold. At the same time, the fact that news flow has largely been negative in the past few months, and is likely to remain so for some time, upside too is likely to be limited. If the rupee retains its recent gains, earnings estimates would need to be revised, as most analysts seem to be factoring in a rupee/dollar rate of 67.
“CY2017 holds promise for the Indian IT. Indian IT will likely grow 8-9% in FY2017E and could grow at same pace or accelerate in FY2018. However, the positives are partly negated by simple roll-over of budgets, awaiting broad policy direction of the new US government leading to soft start to the year,” analysts at Kotak Institutional Equities wrote in a note to clients.