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Software: Things looking up? - Views on News from Equitymaster
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Software: Things looking up?
Jan 3, 2008

The BSE IT index was the worst performer in 2007 down 14% over its 2006 closing levels. Perhaps, on the part of the investors (retail as well as institutional), we believe that deserting IT stocks just because of appreciating rupee was bit premature. While investors may contest that when sectors such as power, engineering and capital goods are giving such high returns then why stick to sectors like software and pharma, which are giving negative returns. Point taken. But then what triggers downturn in a stock? The answer is ‘return of sanity’. Warren Buffet once said, “The stock market is the most peculiar place in the world. Here people are more relaxed after they have bought an overpriced security and have sold an undervalued one”. This sentence was not just for saying but this actually works in stock markets.

The point we want to make here is that when investors started deserting IT stocks, we believed that the fears were largely exaggerated. The contention given was that with rupee appreciating, the margins of IT companies will come down, and so will the return ratios like ROE and ROIC.

We take a look whether this has actually happened? We have compared the Tier I company’s revenues and operating profits in CY06 and CY07.

  Infosys TCS Wipro Satyam
  Jan-Dec '06 Jan-Sep '07 Jan-Dec '06 Jan-Sep '07 Jan-Dec '06 Jan-Sep '07 Jan-Dec '06 Jan-Sep '07
Revenues 127,450 116,510 172,465 160,047 137,478 133,157 60,195 56,410
EBITDA 40,270 35,650 46,527 42,815 31,845 27,144 14,620 12,232
EBITDA margins 31.6% 30.6% 27.0% 26.8% 23.2% 20.4% 24.3% 21.7%

The rupee was trading at 44.11 to dollar on 31st December 2006 and yesterday it ended at 39.42 to a dollar thereby appreciating by 10.6% in CY07. Every 1% change in rupee impact operating margins of companies by around 0.4% and thus liquidating the holdings in this sector seemed valid. However, had that been the case, Infosys’ operating margins would have come down to 27.4% by the end of September 2007, from 31.6% in December 2006. But over the last 9 months (3Q results are yet to be declared), Infosys margins’ have come down by just 1% indicating company’s ability to deliver even in adverse circumstances.

TCS for instance has recorded a margin decline of only 0.2%, which is quite commendable. Wipro’s margins should have been around 18.9% and Satyam’s margins should have been around 20%. Wipro margins have come down mainly because of the string of acquisitions it has made in the low margin segment. But from the data given above, it is quite clear that the margins have not fallen in the proportion of the appreciation of rupee and steep wage hikes affected to counter the talent crunch problem. These companies have been able to achieve this by higher volume growth, better pricing environment and improving the product mix.

What to expect? The IT companies again emerged as the leader in hiring people in 2007. This indicates that the demand pipeline is still very strong as indicated by all these companies. On the supply side, the only worry is the high attrition levels. With the rupee stabilising around the 39.5 to 40 mark and the wage hikes being already affected by these companies, we expect stable margins with a slight negative bias going forward. While this may please the stocks markets on a quarterly basis, in the long run the companies need to spend heavily in R&D because this shall help them achieve breakthroughs in productivity.

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