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Sector Exit Call: IT

There seems to be problems with the Infomation Technology space (IT) in India. What’s the situation?

Increasing Rupee
The rupee is now around Rs. 41 to the dollar. This is mid-may, half of the first quarter of FY 2008, and we have already dipped from 43 in March to 41 today – nearly 5% down. If you consider a growth of 30% for a company, the net growth is now 25% till now.

Note of course that the companies usually hedge by buying future contracts of the rupee against various currencies. But it looks like our companies are seriously under-hedged. Infosys, in it’s annual report 2007, noted that its total hedge, in all currencies is about Rs. 2000 cr. This is less than 20% of their annual income. In fact, they make more than 3500 cr. per quarter, so just about now, their hedges are complete. Every minute from now on that the dollar stays below 43.2 (their guidance rate for hte year) Infosys is making lesser profits than guided. Even TCS is hedged at less than a quarters revenue.

A 5% hit on profits is a large amount, and the guidances of most companies had already been hit by the rising rupee in April; now the situation is much worse.

ESOP dilution
Employee stock options have had FBT on them, therefore companies have asked employees to vest. Typically people exercise in-the-money options, but I believe some employees would have exercised options that are out-of-the-money, meaning their buy prices are higher than the price in the market. This dilution will considerably affect EPS growth. The Tech sector grants a large number of ESOPs and the dilutory effect is gradual – but this time, because of the FBT levy, ESOP dilution was accelerated in march/April and lots of tech companies have a significantly lower EPS growth projection (nearly 3% in Infy and could even be 20% lower in companies like FirstSource)

Typically, in India, EPS growth is not the factor highlighted. But it’s more common in the west. Since you pay a multiple of the EPS, you should look at EPS growth – and if something affects it you should perhaps reconsider your decisions.

The above two factors affect the near term outlook – less than 1 year. If the dollar stays below 42 till June we will see an immediate impact on the 1Q 2008 results. If it continues to stay under 42 for the subsequent two quarters, the fall will significantly affect bottomlines. Further ESOP dilution will muddy the water even more.

I’m not a rocket scientist, so obviously other people have also thought of this. People pay prices based on the future, and if tech prices haven’t already dropped, there may be other factors affecting tech that I haven’t noticed.

But I’m concerned even about the 1 year outlook. At this rate I don’t see a great growth story in tech. The dollar rise is a fundamental event and there is lot of buying interest in the rupee, which is not just FII or NRI interest but also Indian companies getting money from abroad.

ESOP dilution is a one-timer for now, but in lower growth times, dilutory impact is more pronounced. The FBT forces exercise (unlike earlier when vested shares were not exercised for a long time) so the impact on the shares is quite high.

I need to get more data to substantiate this article, since such situations have occurred in the past. Let me try to do that as well.

I work in the tech industry so what I’m saying will affect my job too. But I have no choice – you perhaps do, if you own tech company shares. If there’s no fall yet, these shares may be irrationally high, and bound to head down. Take your call. I’m exiting my holdings in Mindtree and Firstsource. But I’m staying on with Moser baer because of their local growth.

  • kaho pyare says:

    >hi,

    if rupee appreciates by 5%, then their revenues will drop by 5% and their profits will drop by more than 5%.

    Consider their revenues guidance for this year is 4300 Cr. then make profit of 1000 Cr. Now their revenues will be 4100 and profit will be 800Cr only. so drop of 20% in expected profit.

  • Anonymous says:

    >hi..

    i’m somewhat of a newbie..

    if tech stocks do slip up big time as u say..
    as their stock price decreases, would u consider buying them after a significant decline, seeing a bargain?

    In other words, what factors would lead you to reconsider buying tech stocks other than falling rupee? Thank you sir.

  • Deepak Shenoy says:

    >Kaho pyaare: Interesting, but actually if they maintain margins they may make it. You’re assuming expenses stay the same (why shouldn’t they)

    Let’s see for Infy. Their guidance is an EPS of Rs. 80.29 to 81.58 per share. Assuming current esop dilution, they have 57.27 cr. shares this year so they will make around 4700 cr. at the higher end of the guidance.

    This means they spend around 12,500 cr. a year. If we consider their revenue guidance of $4 Billion, that will yield Rs. 16,400 at the current rate of Rs. 41 per dollar. Assuming expenses stay the same, they get earnings of 3832 cr. which translates to an EPS of Rs. 66.91 per share.

    Last year’s diluted EPS was Rs. 67.7 per share.

    Technically this means there will be a reduction in EPS if the dollar averages out at Rs. 41.

    Further ESOP dilution, which they say is about 4 million shares, about 0.75% of current capital and fairly insignificant, is not considered in the above calcultion.

  • Deepak Shenoy says:

    >Anonymous: I think there are reasons to buy tech stocks which are not hyper-dependent on the dollar. Moser Baer for instance, has just started a program of selling DVDs and CDs in India for prices below Rs. 50 per unit. That is going to curb piracy and already there are a number of CDs available in local kirana stores in Bangalore.

    If this catches on, Moser Baer will make an enormous amount of money (low margin, high volume) in this business, and it is completely independent of the dollar. Therefore, this stock has potential. I own it since 2004, and my average buy price is around 210, current price is Rs. 360. Still looks good to me.

    I also think product companies are a better bet than pure service plays. The Infy, TCS and Wipro bandwagon will move on, but they won’t see the astounding growth levels of the late nineties or the last few years. I believe they will hit roadblocks in terms of US slowdown and increased salary/cost pressure in India.

    But these companies may tap onto products by simply acquiring them. Infosys has around 6000 cr. in their bank. They could use it to get into the product space and tap a lucrative market there (finacle is barely a product, but it’s a start). But I don’t have hopes on that – they have never made big ticket acquisitions.

    What I would buy would be stocks like Naukri if their share price comes to more believable levels later this year, and if they use the 170 cr. IPO money for good expansion (acquisitions, more products etc.).

    The tech space is going to change phenomenally if hte dollar slides. Change over to companies that have significant revenues in India, if that happens.

  • The Green Man says:

    >Deepak,
    Don’t you think the rupee appreciating against dollar is a indian phenomenon ? i.e. the RBI is not intervening to make the rupee at some price like 42-43 because they want to control inflation. Once the inflation numbers are cooled off, they would intervene as they don’t want the IT, ITES companies and numerous exporters.

    Vinayaka CA

  • hari says:

    >Hi Deepak,

    I have 2 doubts about one about rise in the Rupee and second about Pharma. How long will this trend continue? Is there any indicative time frame? Even if It is same is will it affect the biggies like Infosys,TCS ,and Wipro (in terms of share price) that heavily?

    By mistake I bought Cipla at 217 now at 208. Have I made a mistake. Is it ok to wait for another 9 months before selling it. I forgot to notice that its 4Q results were below expectations. Also could you suggest a few good Pharma stocks. My picks are Ranbaxy ,Lupin , and Biocon.

    Regards
    Hari

  • Deepak Shenoy says:

    >Green man: Actually the dollar is depreciating against all major currencies. The rupee itself has not deeply appreciated against the euro or british pound.

    I don’t know if RBI intervention will be enough to bring it back up. I believe they’ll run out of money before they can do it successfully. They are issuing another 32,000 cr. of bonds for stabilising the rupee-dollar equation, but that is just $8 billion. In the four months to Feb 2007, RBI had already bought $20 billion. At the same rate RBI will be limited out within 45 days.
    (See this link)

  • Deepak Shenoy says:

    >Hari: Rupee rise, there is no time frame. You have to wait and watch – I don’t see why it won’t affect the biggies, most of htem are hedged only for half a quarters revenues…

    Also pharma wise I have ranbaxy and dr. Reddys. Have heard a lot of good things about Sun pharma but haven’t done an analysis.

    Cipla wise: Perhaps it’s oversold now. I haven’t analysed it either, but it does have potential. Have you checked their results? ANythings awry there?

  • hari says:

    >Hi Deepak,

    I have been analyzing Cipla(price movement)for a year now (though I have started watching stock markets only after my engineering which was 1 1/2 years ago). This stock is highly stable. It never oscillates at all. I also was analyzing the Fund fact sheet of Franklin Templeton.It has invested heavily in Cipla through many of its funds.What happened was one day I was at work,and came back. Saw that the stock had lost 14% in a single day (which never happened before for cipla especially).So I bought this stock aggressively. Later I had a doubt so went and checked it 4Q results.If my memory is right I think its profits was down by 40%. So this bloodshed,dramatic fall in price.
    Is it advisable for me to hold on to Cipla. Also is it ok to buy more once it goes below 200 (Bcoz its 52 year low is 178). Please give me your ideas on the same.

    I too held ranbaxy is it ok to buy it now. Sun Pharma is good.I read in the ET last week that Lupin is doing exceedingly well and its Board of Directors are considering a 1:1 stock split. Is Biocon ok. I also feel that Dr.Reddys is Costly.

    Thanks & Regards
    Hari

  • Deepak Shenoy says:

    >Dr. Reddy’s has a 12 trailing P/E so I’m not sure it’s expensive. Cheaper than most others!

    Cipla needs more research from my end. Dramatic falls in price in a stable stock are dangerous; the 52 week low may just be the breaking point. It seems to be trending downwards, may not be worth staying in.

  • The Green Man says:

    >Hi Deepak,
    Now i think Rupee is also appreciating and Dollar is also depreciating..

    check my post with the comparisons at http://wiser-money.blogspot.com/2007/05/indian-rupees-and-us-dollars.html

    Regards
    Vinayaka CA

  • Deepak Shenoy says:

    >Vinayaka: Interesting post. But you’ll see the dollar’s the worst hit versus the rupee (>10%) while EUR adn GBP are <10%. Some of the rates are pegged to the dollar (like the yuan) which will be similar to the dollar falling.

    Either ways – it’s up to 41.1 today. Looks like the RBI has kicked in. Let’s see how it goes.

  • Soothsayer says:

    >I’d be looking to pick up some Gold ETFs at this point as a good hedge against the depreciating dollar… common sense tells me if you would like to bet your money on airline stocks always take a hedge position with crude oil in the commodities….crude oil and airline stocks are negatively correlated….is these a similar sectoral play that could be a good call in view of US slowdown & depreciating dollar? I’m inclined throw my hat into telecom & retail in stocks and nickel and copper in commodities…Please comment

  • Deepak Shenoy says:

    >Soothsayer: Oil vs airline companies works. In my experience crude oil, the dollar/rupee and oil companies are correlated. If you find the effective rupee cost of oil is up, the oil companies will go down.

    Hedging against gold; I’m not sure because in the recent past gold and dollar both went up at the same time. They might choose to go down together as well.

  • Uday says:

    >Hi Deepak,

    Today many Sugar stocks are up around 10 %. The reason being, increase in international sugar prices. Is it advisable to enter these stocks now.

  • Ritesh Kamath says:

    >Hi Deepak,

    I read a lot about teledata informatics & by the charts it looks that its EPS is increasing in the next year or so & it looks like its profit is more than doubling. But this is not listed on NSE . Is there something fishy here ?

  • Deepak Shenoy says:

    >ritesh: It is listed on NSE btw, symbol is TELEDATAIN.

    I like this stock. Low P/E, very high growth. But it’s IT and the sector is looking weak, though thsi stock has tremendous capabilities in the local industry as well.

    But it may not be the right time to enter. Stock looks weak: Low volumes, five continues gap down lower circuit days, and no interest even when nifty has surged recently. It’s also trading below the 20 day moving average, both on volume and price.

    Wait till the stock recovers with volume – i mean you should have two good up days with volumes around 10 lakh shares, then you can consider investing.

  • Anonymous says:

    >Hi Deepak,

    I agree with what you have said that due to FBT and ESOP equity dilution has happened and with the rupee dollar story the way it is, revenues and margins would be hit for IT companies. I am not aware of hedging and would not go there.

    The sector has some established players like Infosys, TCS and MindTree is another company in whose management I have good faith (for the record I am not an employee of MindTree!!!). These companies have strong fundamentals (in my language a solid management which is investor friendly) hence in the long run they should do well. Plus a lot of these companies do business with European markets, Middle East and Asia Pacific regions also which would provide substantial revenues to these companies. US margins would take a beating but then the companies are planning to increase the rates also from what I read in an article. This would cover some of the rupee dollar impact.

    What do you think about this?

    Also, this ESOP dilution was a one time event due to FBT so going forward the dilution should happen gradually only I would think, or not?

    Moser Baer, would you recommend entering now? Heard that it is giving a bonus of 2:1 in near future?
    Teledata, as Ritesh said, has had a dream run of sorts in the past and had peaked to around 91 odd some time back but now is back @ 65 levels. A lot of people are saying that it is not a good company with not very strong fundamentals but your reply to Ritesh’s comment gives it a promising look. If it has low PE and high growth then why can’t one enter now only rather than waiting for recovery with volume, as you have advised? Any specific reasons for that?

    Cheers,
    Sumeet
    PS1: Thanks for incorporating the “new” suggestion, life becomes easier. The top left column with recent listings always helps to see the latest but within the sticky, it was tough @ times to spot the new entry, now it is visible in the first go.
    PS2: List of books request is still pending.

    Keep up the good work.

  • Deepak Shenoy says:

    >Sumeet: Increasing rates for IT companies is something I’ll have to see work out – honestly price increases in a very competitive business are not favourable.

    TCS is one of the few companies which are less dependant on the US. Most others have more than 70% US revenue.

    Mindtree is great fundamentally, but the sector outlook will pull it down. What I think is that this stock may come back down after the next quarter results or two and then the fundamentals may display themselves. Give it some time before you invest.

    ESOP dilution will appear in the results in the next one year. That means in that time frame, people will be concerned about sentiment and EPS growth will not be as high as expected. That’s why I don’t recommend buying – it’s best to buy after the dilution has occured when the sentiment is negative.

    Moser: I like the stock, and hold it. I have a trailing stop loss set on it, and the bonus issue has been approved which gives it a short term boost.

    Teledata is promising on fundamentals, and has big exposure in India. That’s one reason to look at it – but the volumes are not great. You must believe that whatever I say is already known in the market for days, and that if people haven’t bought or increased the volume of trading, there may not be much movement in the short term.

    Don’t try to create a trend – you don’t have that kind of money (I presume). What you should do is track the beginning of a trend and latch on to it then, and only on stocks which have good fundamentals.

    Good stocks, vs. good time to buy good stocks.