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Saturday, March 7, 2009

Buying Stocks Of IT Companies - How Would IT Stocks Perform Over Next 3 - 4 Years?

TOP 5 IT FIRMS RENEGOTIATED $1.5-B CONTRACTS OVER LAST SIX MONTHS AT MUCH LOWER RATES.

TOP Indian tech firms, such as TCS, Infosys, Wipro, and HCL, are signing new outsourcing contracts at 15-20% lower billing rates than last year, as customers including BT, Bank of America and Citibank renegotiate existing contracts and award new projects at much lower rates.

I was reading this news in Economic Times. Let's try analyzing how this is going to affect investors buying stocks of IT companies.

Over the past two quarters, customers such as Visa, Best Buy, Applied Materials, Nissan, Citibank and Bank of America have been in discussions with India-based service providers, asking them to help these companies cope with lower information technology budgets.

Outsourcing customers are using the downturn as an opportunity to question high margins of Indian service providers. Top five Indian software companies renegotiated almost $1.5 billion worth of outsourcing contracts since September last year at around 15% lower rates.

“Some customers are asking us to let go on our high margins and take offshore projects for as low as $15-20 hourly billing rates,” a senior official of an India-based offshore provider told ET on conditions of anonymity. He recently negotiated contracts with clients such as Pfizer and Novartis.

While HCL Technologies is expected to see its EBITDA decline by half from 22.2% in 2008 to 11.2% in 2011, country’s biggest software company TCS could see its margins go down from around 26% last year to 18.2% over next three years, according to Anand Rathi Research. Wipro, the country’s third biggest tech firm, is also expected to see its EBITDA decline from around 20.1% last year to 13.5% by 2011.

WHAT IS EBITDA?
Earnings before interest, taxes, depreciation and amortization (EBITDA) is a non-GAAP metric that can be used to evaluate a company's profitability.

EBITDA = Operating Revenue – Operating Expenses + Other Revenue

“Things have really turned bad, this week we came across almost $15 per hour rate for an Oracle implementation project for an engineering customer,” said a senior official at a leading tech firm who also requested anonymity.

So with margins going down, which is measure for profitability for the company, earnings per share (EPS) of these companies would also be reducing in next 2-3 years. With reductions in EPS what do you expect the stocks to do in stock markets? Naturally lower growth in stock prices. Indian IT companies would be able to outdo this slower growth only with volumes and more number projects which could add up to the financial numbers. This seems to be difficult in such financial crisis which has spread its wings globally.

With margin numbers expected to go downwards mentioned above (22.2% in 2008 to 11.2% in 2011 for HCL, 26% last year to 18.2% over next three years for TCS and around 20.1% last year to 13.5% by 2011 for WIPRO), this only reflects slowing the growth of Indian IT Companies in terms of profits and so the stock appreciation. It is a well known fact that global IT majors like IBM are functional at the margin rates of around 10%. Indian IT companies would not either enjoy the profit margins of above 20 - 25 - 30% for longer time.

Last word:
Whatever growth Investors have experienced in last 10 years by IT stock buying, would be difficult to see in next at least 3 - 4 years. So do not expect exceptional returns like 30 - 40% per year from IT stocks in 2009 - 2010 - 2011 - 2012. This is my personal opinion. Being an IT professional myself and knowing (and experiencing too!!) the IT industry from within, this could be the only opinion I could give on IT Stocks. There could be exceptions in certain cases but chances are bleak for overall IT Industry.

1 comment:

  1. Vinay:
    It is a part of natural business cycle that cost should come down over a period of time. That's how business innovate or survive. Now we in India have a different perspective. IT was booming and hence there was no talk about cost reductions. At first, the labor arbitrage was good enough for MNC to come to India. Now will be time for operation cost reduction, and hence they are demanding it..... Indian IT and BPOs will have to adapt to this cycle.

    ReplyDelete

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