FMCG companies are overvalued and pharma companies, with their legal battles and pricing pressures, are simply too complicated. That’s why the market has latched on to a new blue-eyed boy in recent months — technology.

The BSE IT index, up 30 per cent in the last three months, is now the best performing sector index in the last one year. IT stocks gained three times as much as the Sensex and beat the 20-22 per cent returns from FMCG and pharma stocks. But if you missed the bus, you needn’t worry, for there is still plenty of opportunity to make money off software stocks.

For, even after their recent surge, stocks of most software players — both large and mid-tier — trade at reasonable valuations. Many even seem under-priced in relation to their earnings potential. Here’s why.

Growth revs up

Both mid-sized and large IT companies have seen their volume growth pick up in the last six quarters. In the last one year, TCS, HCL Technologies and Infosys witnessed a 10-18 per cent increase in volumes. A big factor working in their favour, obviously, has been the revival in the US economy.

For the top-tier companies, North America really matters, because TCS, HCL Technologies, Cognizant and Infosys derive 52-65 per cent of their revenues from the region. What’s more, this growth isn’t restricted to just one segment; it is broad-based. So, while banking, financial services and insurance (BFSI) (accounting for 25-43 per cent of revenues for top-tier players) grows at a good pace, manufacturing and retail are growing at double digits for most of these companies.

For TCS and HCL, even the beleaguered telecom vertical is showing signs of revival. The story of broad-based growth across verticals is repeated with large players such as Tech Mahindra and mid-tier IT companies such as MindTree, Hexaware, NIIT Technologies, Persistent Systems and KPIT Cummins..

The mid-tier companies have their own set of clients with little or no overlap with the larger pack and have sharpened their focus by working on fewer areas.

In fact, mid-sized companies are now able to participate, and share in, the deals won by top-tier vendors from large outsourcers. For example, MindTree is now a new vendor added along with Infosys and global majors in a deal from a large American banking client.

The other key trend is the growth in value-added services apart from the traditional application development and maintenance (ADM) business.

Away from ADM

ADM accounts for a third to 42 per cent of top-tier IT players’ revenues. Now, these offerings have grown at a healthy pace for TCS, Cognizant and mid-tier IT companies.

For HCL, the growth has been led by its strong point — infrastructure management services, along with application services.

For Infosys, package implementation and consulting, a high-margin service, has led the growth.

While most of the top-tier players maintain a certain level in the ‘bread and butter’ application offering, they are chasing growth in different ways and playing to their strengths as seen from the different service lines that are leading growth. Management commentary across the spectrum indicates that discretionary spending too has witnessed a revival, which signals steady growth in opportunities for Indian IT vendors.

Deal wins strong

The growth in volumes has been augmented by significant traction in new deal wins too. Top IT companies have seen improving growth in large deals of $100 million and $50 million.

For instance, TCS and Infosys have added two-five clients in the $100-million range while HCL and Wipro have added more deals in the $30-50 million range. The top clients are ramping up their engagement with most mid-tier and top IT vendors as well, suggesting that these companies are able to mine their existing clientele significantly.

Interaction with company managements suggests that many companies are investing the benefits accrued from the falling rupee in strengthening their sales force. The industry is now also looking at shoring up margins.

Large IT players already derive 40-50 per cent of revenues from fixed-price contracts, which ensure better realisation than time and material projects. Now mid-sized players too are making this shift. Again, recruitments have been selective as a considerable bench strength has been built up over the past three years. This also helps in containing margins significantly as manpower costs account for 50-60 per cent of revenues for most IT players.

Gains from falling Rupee

The financial year started with levels of Rs 54-55, but now a dollar is valued at over Rs 66. The 19 per cent depreciation in the rupee since the beginning of the year should theoretically deliver an improvement in the range of 400-450 basis points in operating margins of players. But the actual benefits depend on the quantum and tenure of the hedges taken by individual players. TCS, Infosys, Wipro and HCL Technologies have locked into fixed exchange rates for 15-33 per cent of their estimated revenues for this year.

While many players hedge their revenues for terms as long as one year, Infosys takes hedges for just two quarters. This should allow benefits from a depreciating rupee to flow through more quickly to its revenues.

Presently, top-tier IT companies have hedged their revenues at exchange rates of Rs 55 or even less to a dollar. With the rupee moving well away from this level, companies may let their options expire worthless incurring forex losses on hedged contracts.

Now, gains from the rupee may help compensate IT companies for the 6-8 per cent wage hikes announced earlier this year.

Valuation comfort

Despite the rally in the prices of IT stocks, valuations are comfortable.

Barring TCS, which trades at 23 times its likely FY14 earnings, none of the IT stocks trade at a level that an be considered as highly pricey as they are trading at a lower PE than their past five years’ average multiple (see table).

Valuations remain modest because most IT stocks did nothing over much of 2011 and 2012, when their earnings over FY2011-13 grew at 17-50 per cent in the case of top-tier IT companies and 8-79 per cent in the case of mid-sized companies.

This rally may be a combination of playing catch-up and also improving fundamentals of companies testified by strong results.

But TCS has earned that premium by being the leader of the pack as it delivered broad-based growth consistently. In the light of its rich valuation, investors can retain their holdings in the stock and accumulate when the stock corrects on broader market cues.

Infosys trades at 17 times its estimated FY14 earnings, which is not expensive. But given its dependence on discretionary spends and the lumpy nature of its earnings, investors with a relatively higher risk appetite can buy the stock.

HCL Technologies is the best pick in the sector with valuations at just 14 times 2013-14 earnings and also robust earnings prospects with as much consistency as TCS. Investors can buy the stock.

Wipro trades at 17 times future earnings. This makes it expensive in view of its feeble revenue growth and moderate earnings expansion. Although the company has guided for a better outlook, the stock’s rally seems to have factored this in. Investors can look to book some profits in the stock.

Tech Mahindra (including Mahindra Satyam) appears a good buy with the merged entity likely to be a large $3-billion player soon. At just 11 times FY14 earnings, valuations are at a discount to top-tier players. MphasiS, although trading at moderate valuations, does not seem that attractive currently as revenue growth is still anaemic and profits aren’t picking up in line with peers. Investors can monitor the stock for earnings improvement before taking the plunge. Among the mid-sized companies, MindTree and Hexaware, around 10 times FY14 earnings, present a good opportunity. Among niche mid-tier players, KPIT Cummins can be bought at current levels, while Persistent Systems can be accumulated over time on corrections.

> venkatasubramanian.k@thehindu.co.in

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