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Software companies could deliver the numbers in Q2 FY08, but the sector may not outperform over the next year.

The apple of investors' eyes for more than a decade, the information technology (IT) sector has only lost money for shareholders this year. Software companies are in a soup from both ends.

On one side, the Americans wouldn't pay them more for their services, and on the other, the depreciating dollar wouldn't let them take home more rupees. And now, talks of a US slowdown are doing the rounds in the markets, following the credit crunch brought to you by the subprime crisis.

The first act of the show has been played well by the first quarter results, which caused considerable damage. The scene for the second act is being set up by global financial majors, key customers of Indian software services companies, issuing profit warnings and retrenching people.

As we close into the announcements of Q2 results this week, it is difficult to hazard a guess on what directions the stocks would take.

Seasonally strong

Most IT companies affect wage hikes in the June quarter every year, and the result is usually seen in the first quarter numbers. Therefore, the second quarter results have been historically better than Q1, for all the players.

This year, the margin pressure arising out of wage hikes was compounded by the rise in the rupee, which gained nearly 7 per cent against the dollar during the first quarter, chomping away the growth in earnings drastically.

During the second quarter, the rupee has appreciated just around 1.6 per cent, and IT companies too, have reworked their hedges at around Rs 39 a dollar, which puts them in a relatively safer position. Further, new contracts are being signed at slightly higher prices which should aid in improving realisations, thus protecting margins.

Volume growth too, does not seem under any threat so far. Says Asit Bhandarkar, a fund manager at JM Mutual Fund, "There is no concern on the business front for IT companies. However, the broader issue of currency appreciation still remains as realisations are taking a hit."

American blues

"Prior to the subprime crisis, there was a hunch that the US economy may have a soft landing," says Andrew Holland, managing director -  strategic risk group, DSP Merrill Lynch. "Now, the soft landing is not too soft after all," he adds.

The impact of the subprime-led credit crunch appears to be far-reaching as global financial majors issue profit warnings and announce lay-offs. "If you retrench staff, you do not outsource; so there would be pressure on the outsourcing sector in the short run," says Holland.

On the other extreme, there is another set of people who believe that a slowdown in the US will boost offshoring, and hence outsourcing majors will rather gain from it in terms of volumes. However, the outlook is uncertain until the end of the year, when US companies review their budgets, and thus, their IT spending as well.

If there are any cuts in the IT spend at the clients' end, the impact will surely be seen on Indian vendors, but with a lag effect of about six to nine months. "So far, there has been no indication of ramp downs from any of the clients of IT companies is what we hear,"; says Bhandarkar, "but there is no way to estimate what is going to happen when the IT budgets are reviewed."

Currency crash?

Markets were awash with inflows from foreign institutional investors' (FIIs) and the stock market indices soared, right after the US Federal Reserve reduced rates by 50 basis points last month. Increased foreign investments however spelled doom for the currency situation, as the dollar whooshed below the Rs 40 mark.

A recent UBS report has pegged the dollar at Rs 39 by December 2007 and at Rs 37 by the end of 2008. And by now, this should not surprise anyone, since it is rather the weakness in the dollar which is being reflected in the continuing appreciation.

Therefore, for a considerable time to come, IT majors have to get used to a strengthening rupee scenario, finding alternative ways out such as increasing their dollar expenditure.

Time to recognise

It is clear that even if there is a slowdown in the US economy, it is not going to show any impact before the next six-nine months. Further, the impact of changes in currency rates will depend on each player's ability to hedge its exposure.

In such times of uncertainty, Indian IT and outsourcing players are left with few options. "The only way for IT companies to survive this crisis is by increasing realisations and improving efficiencies," opines Bhandarkar.

Increased geographical diversification, and adding new industry verticals appears to be another option. So far, the big players have remained highly dependent on the US among geographies, and on banking, financial services and insurance (BFSI) among industry verticals.

If the US slowdown is prolonged - the environment is still to emerge clearly - smaller companies, which are already in a soup, will find the going more difficult.

"Compared to our larger peers, our profits are more sensitive to any change in currency movements as we rely on a higher proportion of offshoring," says Rostow Ravanan, chief financial officer, MindTree Consulting [Get Quote].

"Larger companies are better placed to deal with a slowdown too, since they have a proven track record, long-standing relationships with their clients and big ticket projects," Bhandarkar adds.

Over the years, Indian IT majors have moved into taking up contracts which form a part of the clients' non-discretionary IT spend thus assuring sticky revenues. Smaller players are still vulnerable on this front.

Up or down?

The sentiment for the sector on the streets is mixed, as it was beaten down largely due to the rupee appreciation. So far, there have been assurances that the subprime crisis has not affected the Indian IT companies, preventing further declines of IT stocks.

However, concerns over an impending slowdown in the US economy have resulted into risk aversion among investors, and the price-earnings (P/E) multiples that the IT biggies commanded have contracted. Historically, Infosys [Get Quote] traded at a one-year forward multiple of 25-28 times, which has now come down to 22-24 times. To some, this is a good time to enter.

"Valuations are fair after the correction, and there is ample liquidity in the markets since there is new money flowing in after the US Fed rate cuts,"; claims A Balasubramanian, chief investment officer, Birla Sun Life Mutual Fund. "Considering the present situation, it appears that the sector may not outperform, but neither will it under-perform," he adds.

Valuations

Given that the industry expects volume growth to remain strong in the near term, one can assume that the results of a couple of imminent quarters wouldn't really show any sign of gloom.

It remains to be seen whether there are any cuts in the capital expansion plans or IT spends at the US clients' end, which will further set the direction for Indian IT stocks. However, this uncertainty does not seem to be fading before the end of the year.

The potential upside from the sentiment of strong volume growth appears to be factored-in in the present valuations of large-cap IT stocks.

In spite of chances of large players weathering the storm, the glum outlook makes a strong case for investors to stay away from mid-cap IT counters, until clarity emerges.

Most large-caps being reasonably valued, one has to take a pick on the prospects of individual companies. Apart from this, currency hedges and geographical diversification too, have become important parameters.

TCS [Get Quote], HCL Technologies [Get Quote] and Infosys (in that order) have built-up the largest hedge positions as on June 2007. Although unlikely, any improvement over the rupee guidance declared last quarter by tech companies will surely reflect positively in stock prices.

Potential candidates: Infosys, Wipro [Get Quote] and Satyam [Get Quote]. TCS and HCL Tech are likely to report robust volume growth, with the former reporting a moderate rise in realisations too.

Among the smaller players, MindTree Consulting and Mphasis BFL may report strong revenue growth, while Hexaware [Get Quote] and iGate Solutions could be under fire due to slack revenue growth.

Investors may hold on to their IT portfolios with patience, and new buyers with a slight appetite for risk could log in to large-caps and expect rewards but not in the near term.