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Sector Exit Call: IT


There seems to be problems with the Infomation Technology space (IT) in India. What’s the situation?

Increasing Rupee
The rupee is now around Rs. 41 to the dollar. This is mid-may, half of the first quarter of FY 2008, and we have already dipped from 43 in March to 41 today – nearly 5% down. If you consider a growth of 30% for a company, the net growth is now 25% till now.

Note of course that the companies usually hedge by buying future contracts of the rupee against various currencies. But it looks like our companies are seriously under-hedged. Infosys, in it’s annual report 2007, noted that its total hedge, in all currencies is about Rs. 2000 cr. This is less than 20% of their annual income. In fact, they make more than 3500 cr. per quarter, so just about now, their hedges are complete. Every minute from now on that the dollar stays below 43.2 (their guidance rate for hte year) Infosys is making lesser profits than guided. Even TCS is hedged at less than a quarters revenue.

A 5% hit on profits is a large amount, and the guidances of most companies had already been hit by the rising rupee in April; now the situation is much worse.

ESOP dilution
Employee stock options have had FBT on them, therefore companies have asked employees to vest. Typically people exercise in-the-money options, but I believe some employees would have exercised options that are out-of-the-money, meaning their buy prices are higher than the price in the market. This dilution will considerably affect EPS growth. The Tech sector grants a large number of ESOPs and the dilutory effect is gradual – but this time, because of the FBT levy, ESOP dilution was accelerated in march/April and lots of tech companies have a significantly lower EPS growth projection (nearly 3% in Infy and could even be 20% lower in companies like FirstSource)

Typically, in India, EPS growth is not the factor highlighted. But it’s more common in the west. Since you pay a multiple of the EPS, you should look at EPS growth – and if something affects it you should perhaps reconsider your decisions.

The above two factors affect the near term outlook – less than 1 year. If the dollar stays below 42 till June we will see an immediate impact on the 1Q 2008 results. If it continues to stay under 42 for the subsequent two quarters, the fall will significantly affect bottomlines. Further ESOP dilution will muddy the water even more.

I’m not a rocket scientist, so obviously other people have also thought of this. People pay prices based on the future, and if tech prices haven’t already dropped, there may be other factors affecting tech that I haven’t noticed.

But I’m concerned even about the 1 year outlook. At this rate I don’t see a great growth story in tech. The dollar rise is a fundamental event and there is lot of buying interest in the rupee, which is not just FII or NRI interest but also Indian companies getting money from abroad.

ESOP dilution is a one-timer for now, but in lower growth times, dilutory impact is more pronounced. The FBT forces exercise (unlike earlier when vested shares were not exercised for a long time) so the impact on the shares is quite high.

I need to get more data to substantiate this article, since such situations have occurred in the past. Let me try to do that as well.

I work in the tech industry so what I’m saying will affect my job too. But I have no choice – you perhaps do, if you own tech company shares. If there’s no fall yet, these shares may be irrationally high, and bound to head down. Take your call. I’m exiting my holdings in Mindtree and Firstsource. But I’m staying on with Moser baer because of their local growth.


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