Retail Investors can wait for More Consolidation in the IT Sector
Date: Tuesday , December 27, 2016
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BSE IT index is down by 4 percent during the last one year and has significantly underperformed the broader index like Sensex that has moved up by 12.3 percent during the year. On a sectoral front also the IT index has underperformed some of the sectoral indices like bankex (up 21 percent), auto index (up 28 percent) and consumer durables (up 17 percent). Some of the under-performance in the export-focused IT index could be attributed to a relative preference to the cyclical space that has done better in a benign interest rate environment and measures taken on the policy front. Good monsoon and general revival in sentiment on the back of pay commission payments have also revived some of the consumption demand. So, on a relative portfolio allocation, the domestic-focused sectors like auto, consumers and so on, has done relatively better and have seen more interest from institutional investors.
The underperformance got accelerated with the recent event of \'Brexit\' that has created uncertainties on the businesses that are present in the UK. Most, large IT companies have around 24-30 percent of their business coming from Europe. In the near term there is a possibility of delay in budget approvals, and also the overall spend pipeline could slow down. However, the near-term concerns aside there are also longer term structural problems that are staring at the face of the IT sector.
Indian IT companies are today suffering from two-three structural issues. Historically, the bread and butter business of many of the IT companies was based on labour arbitrage between India and the developed world. However, now there is an increased trend towards automation that could reduce the requirement of pure headcount-based linear business models that were prevalent earlier. Secondly, the firms that were heavy on Infrastructure Management Services could see pressure from new emerging cloud-based services, which could risk incremental deal flow in this domain. Thirdly, incrementally the cost of doing business offshore is also going up with wage cost inflation and also the visa charges going up significantly. The IT companies have also shored up their employee strength in the developed market and hence increasing the cost of doing business.
New-age business imperatives have forced lot of firms to focus on SMAC (Social, Mobility, Analytics, Cloud) and nimble-footed companies that have been able to channelize their energies on these niche areas would possibly do better. In the current environment, where growth has become a concern for some of the large IT players, on a large base, it would be difficult for them to re-rate significantly from here and they may continue to consolidate at current levels. For a long-term investor, it would make sense to look at this space once prices for these companies correct further and offer greater headroom from a risk-reward perspective, or one is willing to hold on to some of the stocks for a longer term to tide over any near-term underperformance risk.
Smaller, mid-sized IT companies that have a greater focus on their limited set of niche business offerings and are better equipped to see much stronger growth going ahead and hence make a better investment case. At this point, the best advice for retail investors would be to wait for some more consolidation in the space and look at accumulating the IT stocks probably at lower levels. With good RoEs, high free cash flow generation and sound quality of management the IT stocks would probably attract investor interest at lower levels.