Mumbai: The Union budget dealt a painful blow to investors in Indian information technology (IT) stocks by imposing a tax on buyback of shares. IT companies have increasingly resorted to buybacks to return cash to shareholders, since they were more tax efficient. The new 20% tax has put a spanner in the works.

Considering that a high rate of cash return in recent years had propped up IT stocks, it isn’t surprising that investors are disappointed. The Nifty IT index fell 2.5% on Friday after the budget was announced, double the rate at which the broad Nifty 500 index fell. And that wasn’t all. The finance minister also said the government would propose to markets regulator Securities and Exchange Board of India that minimum public shareholding in listed companies be increased to 35% from the current 25% threshold. If implemented, this would require large stock sales by companies such as Tata Consultancy Services Ltd and Wipro Ltd, where promoter holding is above the threshold.

With these twin setbacks, the focus would necessarily shift to the financial performance of IT companies. And the picture here is not pretty. While revenue growth has steadied for some companies, margin woes continue.

Indian companies are adversely placed, with utilization levels already at optimal levels and talent crunch leading to higher wage costs, said Ashish Chopra, senior group vice president-institutional research (technology) at Motilal Oswal Financial Services Ltd.

“(Profit) margin will likely decline across companies on a year-on-year comparison," analysts at Kotak Institutional Equities said in a June quarter results preview note. “While the reasons for decline will vary across companies, the broad factors are localization and increase in cost structure in the US, investments in digital and large deal-transition costs. Expect moderation in earnings assumptions ahead."

As the chart shows, margins of IT companies have fallen in the past five years, across large-sized and mid-sized firms.

While normally, the annual depreciation in the rupee took care of cost inflation, this hasn’t been the case in recent years. Companies have struggled on the margins front because of multiple factors such as pricing pressure in the traditional IT services business, where they had a large exposure; higher on-site costs due to US visa restrictions; and a relatively low scale of operations in the upcoming digital services space.

(Graphic: Paras Jain/Mint)
(Graphic: Paras Jain/Mint)

While margins are under pressure, it’s not as if revenues are growing at an impressive pace either. No company is talking about a better FY20 when compared with FY19, barring a few who are coming from a low base, said Chopra.

Constraining the outlook are growing headwinds for financial services, a large business vertical for Indian IT. The uncertain global economic environment is undermining the recovery.

“Banking (and) financial services firms continue to face challenges from slowing global growth, a low interest rate environment, escalation of trade tensions and Brexit uncertainty," analysts at Kotak Institutional Equities said in a note. “We expect demand in the financial services vertical to moderate through the course of FY2020E."

The growing spends on new-age technologies will help the firms mitigate the impact of the sluggishness in the banking and financial services sector to some extent. “We also expect Indian IT outsourcing firms to continue to get a good share of the spending on new technology," said Ravi Menon, an analyst at Elara Securities (India) Pvt. Ltd.

But since overall earnings growth expectations are unexciting—earnings are likely to grow by about 10% on average in the next two fiscals for large IT firms—there isn’t much reason to get excited about IT stocks. In the past, investors were drawn to these counters because of the generous cash return policy. But the buyback tax has upset the cart.

Kotak’s analysts said buybacks for firms with a post-tax yield on cash of 5% would be earnings per share (EPS) accretive if they are done at a price-to-earnings (P/E) multiple of less than 20 times. The hurdle rate now rises considerably, with EPS accretion guaranteed only when the buyback is done at a P/E multiple of less than 16.7 times. With large IT stocks trading at higher valuations, gone are the days of buybacks providing a boost to EPS and return ratios.



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