What ails India's IT industry?

The tech sector is in turmoil, but are investors correct in assessing that the sector is now ex-growth.

IT services or the technology sector in India is going through considerable stress and a bout of dramatic stock underperformance. Investors of all types are now deserting the one-time darlings of the stock market. The large caps are down 20-25 per cent in absolute terms, wherein the broad market is up more than 20 per cent. This is huge underperformance and that too within nine months. The picture is even worse if you look at the smaller IT companies. Many are down 30-35 per cent in absolute terms.

Such a divergence in performance is both unusual and painful (for those invested in tech), given the extent of negative price action now feeding on itself. In the sense that the price action of tech is forcing investors who cannot stomach the underperformance to liquidate their holdings in all IT companies, this liquidation causes further negative price action, which forces still more selling and the cycle gets repeated.

What the sector is undergoing currently is something which the folk at Bernstein in the US call growth purgatory. This is a process wherein the erstwhile high-growth stocks get gradually derated as their growth slows and sector leadership changes. Basically investors re-assess the growth outlook of the affected sector and typically find another group of stocks with stronger, more visible growth. Growth investors then move their investments to these new sectors (causing PE expansion) and out of the former growth stocks (causing PE compression).

As the investor base changes, the former growth stocks keep getting de-rated till they become cheap enough to attract the value guys to invest. This process of transition in the company's investor base from growth investors to value investors is called growth purgatory and is a painful and prolonged period of underperformance for the company concerned. Basically the affected company has to go through a kind of no man's land where it is growing too slowly for growth investors and momentum investors to hold but its stock price is still not cheap enough for value investors to buy. Either the company becomes cheap enough to attract the value investor or fundamentals improve, growth re-accelerates and the growth and momentum guys re-enter.

This, to my mind, is what is happening to the tech sector in India, investors are questioning the growth status of Indian IT companies. It all began with the strengthening rupee and its impact on margins, and has now created fears of a possible US recession and its impact on the top line of IT giants. Basically investors have figured out that even the best tech companies will have an earnings compound annual growth rate of only about 15-20 per cent over the coming three years (with taxes hitting earnings in 2010). Given the exuberance in India these days, 15-20 per cent earnings growth seems quite pedestrian as people argue that today's new growth favourites, the capital goods and infra stocks, can deliver 30-40 per cent growth for years to come and that too with very high visibility. If IT stocks can now only grow at 20 per cent, why should they trade at a premium to the market is the question asked by investors. Independent of the rupee, has not the law of large numbers caught up with the IT giants?

Now is the market right in assuming that the tech stocks have gone ex-growth? Or are we just seeing temporary difficulties, for if the stocks are truly ex-growth then we have more de-rating ahead; otherwise the stocks are probably near a buying point. I have just listed some factors to consider this issue.

• The 15-20 per cent earnings trajectory over the coming three years may not be fair as a long-term proxy, as this year is unusual with an exaggerated movement of the rupee and 2010 is probably the year of maximum tax incidence (post-2010 the SEZ benefits start). It may not be inconceivable that in the post-2010 period growth actually re-accelerates.
• As IT companies have broadened their service offerings, they have multiplied their addressable market. Till six months ago, the Nasscom 2010 vision was on track. Today investors dismiss these same targets of 25-30 per cent revenue growth, though any survey you read still indicates the huge growth runway available for offshoring.
• While everyone is assuming that the current rupee appreciation from 44 to 40 will kill the margins of techland, the rupee appreciated from 49 to 43 between 2002 and 2006, and the industry was able to handle this type of appreciation because it was more measured. The problem today, besides the level, is more the speed of appreciation, and lack of preparedness. As the rupee stabilises we may see some margin clawback as companies respond to the new exchange rate reality.
• If you believe, like some do, that the rupee will keep appreciating forever and at this pace, with 35 being the next logical stop, then I would argue that a lot many sectors beyond tech will have a problem. Most industries in India, even if they are totally domestic-focused, sell at import parity pricing. If the rupee continues to appreciate at this pace, will capital goods and commodity producers really have no margin stress as the market seems to be implying today?
• The IT majors are all cash machines, and will be sitting on $1-2 billion of cash each. These cash mountains can be used for inorganic purposes, and share buybacks or dividends, and give companies great flexibility to boost returns. Investors today are only paying for growth, irrespective of capital efficiency and free cash. The IT business model is extraordinarily capital-efficient and generates free cash, and investors will recognise the value of this at some stage. Also while 20 per cent earnings growth looks pedestrian today, it may not be so always.
• Investors are also giving the managements of IT giants little credit for being able to rejig their business model. As the reality of the rupee at 40 sinks in, one will see a response from IT players. They will push to accelerate price hikes, tighten utilisation, move to other geographies and innovate on their labour pool. Just the fact that we have seen a big margin compression in Q1 does not mean that IT companies have no means to counter this, if given time. Yes, margins will be lower then they used to be, but maybe not as low as the market is implicitly assuming.
• If investors are right and the IT industry is going to slow considerably over the coming years, an additional point to ponder is the impact this slowdown will have on India as a whole. For, as many analysts have pointed out, tech growth is driving large parts of our economy. Who will use all the commercial real estate? Will job growth and demand for consumer non-durables get impacted? Can the tech sector get hammered by investors for slowing growth, and is it possible for this to have no impact on the growth of any other sector?

The tech sector is in turmoil, and has been hit by the perfect storm, but are investors correct in assessing that the sector is now ex-growth? With IT majors now trading at 15 times forward earnings, this is something worth thinking about, for if the growth purgatory were to play out fully, IT stocks will probably bottom out at 12-14 times earnings, implying further significant downside. If investors are wrong, then this may be a great entry point to get into world-class business' trading at reasonable multiples and going through temporary difficulties.

Each investor will have to choose which side he/she is on.