The Information Technology (IT) sector is bearing the brunt of the expected economic weakness in the US and Eurozone. The NSE IT index has underperformed the Nifty by 5.5% in the last one year.
IT sector derives almost 85% of its revenues from the US and Europe and these two areas are unfortunately going through a rough economic phase. The US is by far the largest contributor to the IT sector revenues with its contribution at around 60% to 65% of total revenues. The US is seeing a period of low growth and high unemployment with growth forecasts for 2011-12 revised downwards by 50bps to 100bps by various economists. Unemployment rate at 9.1% in August 2011 is 450bps higher than what it was four years back. The worries on US government debt, which has led to a downgrade in credit rating and the proposed cuts in spending to rein in the budget deficit which is expected to touch 79% of GDP in the coming years will tie the government’s hand in reducing unemployment. Low growth in the US coupled with high unemployment is not a positive sign for the IT sector that depends on orders from US corporations and government for revenues.
Europe, which contributes to around 20% to 25% of IT sector revenues, is reeling under sovereign debt issues and there are indications that it will go into recession in the second half of 2011. The UK, which is running a debt to GDP ratio of 75%, has adopted austerity measures to bring down the deficit. Debt ridden countries in the Eurozone such as Greece, Portugal, Italy, Spain and Ireland (debt to GDP ratios in all these countries between 70% to 130%) have all been forced to adopt austerity measures to bring down debt. The austerity measures are leading to economic growth in these countries falling sharply and going into negative territory. The large economies of Germany and France are also seeing the effects of weakness in the Eurozone with second quarter 2011 growth coming in well below expectations at 0.1% and 0% respectively. Weak economic growth in the Eurozone will impact the IT sector revenues as corporates and governments in the Eurozone cut down spending.
IT sector in the Nifty
The IT sector has close to 13% weight in the Nifty index. The performance of this sector will impact the Nifty significantly due to its high weight. The weights of stocks in the Nifty and the relevant valuation metrics are given in Table 2 and Table 3 respectively.
The valuation of the IT stocks look expensive in the light of a slowdown in the economies of its largest revenue contributors, the US and Europe. The market capitalization (market cap) to sales ratio at 2.7 (HCL Tech) to 5.5 (TCS) is high given the headwinds facing the sector. The pricing power of the IT companies will also come under a cloud given cuts in spending by corporates and governments in US and Europe. IT sector is facing margin contraction on two counts a) Budget cuts by corporates and governments and b) inflation and rising cost of infrastructure. Point a is documented above. On point b, Inflation in India has averaged 9.6% for 2010-11, the highest seen in the past ten years. High inflation is leading to higher wage costs for the IT sector and the sector is largely dependent on human resources. The IT sector requires space, i.e. land to create infrastructure for its outsourcing activities. Cost of land has gone up multifold in the last ten years. Hence wage price inflation coupled with rising cost of infrastructure will lead to margin contraction as the pricing power reduces due to problems in US and Europe.
Given the headwinds facing the IT sector the valuations of IT stocks in the Nifty index are not cheap. Unless the sector changes its geographical concentration or growth in US and Europe surprises on the upside it will be difficult for technology stocks to significantly outperform the broad index. Unfortunately none of the IT companies in India have great products or have great innovation skills to go up on the growth path like a Google or a Facebook. It is high time the cash rich companies (cash is almost 10% to market cap) deploy the cash for innovation.
IT sector will outperform the broad market if…
- Strong Mergers and Acquisition activity takes place with deep pocket global majors buying into the Indian companies.
- Consolidation in the Industry improves pricing power for the majors
- The cash rich companies use cash effectively to generate higher ROE (Return on Equity)
- Global outsourcing picks up pace