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IT stocks: Where to from here? 
(Mon, 25 Oct Pre-Open) 
 
The past week was mixed for the world markets. As for the Indian markets, these gained marginally by around 0.2%. The key sectors that led the gains in India were pharma and oil & gas. IT stocks were also amongst the gainers. This was largely led by a mixed performance from the two IT behemoths - TCS and Wipro. So while the former reported a robust growth in its business for the quarter ended September 2010, the performance of the latter was lacklustre.

As far as IT stocks are considered, in general, these have outperformed the broader markets over the past few months. Even the comparative performance over a year has been better for IT stocks.

Source: BSE

So where are these stocks headed in the future?

One factor that determines the future of any stock is how expensive or cheap it is trading in the present. And as far as IT stocks are concerned, especially the large caps, these aren't trading at any reasonable valuations as of now. The BSE-IT index is trading at a P/E of 26.2 times as against the BSE-Sensex P/E of 23.7 times. Of course, IT companies in general are growing at a faster rate than the average growth rate of the BSE-Sensex companies, but these valuations are not something we will call as cheap. As such, the valuations do not hint towards a bright mid-term future for these stocks.

Talking about the long term, business fundamentals will be the biggest drivers for these stocks. And two variables that suggest riskier times ahead for IT companies are - one, the rupee's appreciation against major global currencies, and two, rising employee base that can bring in challenges of managing the same.

As far as rupee appreciation is concerned, this is something that is not in the hands of Indian IT companies. With India seeing a continuous surge in FII inflows, the rupee is showing continued signs of strengthening. And this is bound to impact the margins and profits of IT companies. As a rule of thumb, a 1% appreciation in the rupee against the US dollar negatively impacts Indian IT companies' operating margins by around 0.3% to 0.4%. With rupee appreciating continuously, it will be tough for these companies to ward-off any challenge to their margins.

The second risk, we believe, is related to the business model itself. Indian IT companies' bread and butter business is to provide IT services to their clients. This requires these companies to continuously add to their employee base to grow their revenues. Infosys and TCS, the two largest IT services companies in India, are looking to add 40,000 to 50,000 employees to their already burgeoning bases over the next few quarters. We believe this pace of hiring is unsustainable. Not only is this on account of the unavailability of quality talent in the country. But this is also likely to lead to huge employee management challenges in the future.

We are already seeing these companies facing rising attrition quarter after quarter. Every employee leaving these companies is a big cost, given that the companies had spent their time and money on training him or her. And this situation is just worsening. This can be seen from the average attrition of the top four IT firms, which stood at around 10% in 2QFY10 and is currently at almost 17%. Now with these companies looking set to multiply their employee bases, we believe they are just adding to their future risks.

So, overall, we are not much enthused by IT stocks as of now. While growing in the face of big opportunities won't be difficult for these companies, especially for the larger players, it is managing such a growth that can pose as a big challenge in the future.

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