Indian IT services companies – multiples should de-rate materially
If you are an analyst covering the Information Technology (IT) sector in India, chances are that you might not have remembered that India’s Union Budget was on 5th of July. Companies in your sector derive over 90 percent revenues from across borders; what could the finance minister have done to impact IT! And yet, I think they are among the worst hit in this budget; read on…
First, buy back of equities will now attract 20 percent tax, the same as dividends. Mature IT businesses throw large free cash flows (in the range of 75% to 100% of cash profits), and large companies distribute majority of it. Think of an IT company that generates free cash equivalent to 90% of cash profits, distributes a third of it as dividends, and two-thirds through buy backs. For that company, this budget has permanently eroded 12% of its value (20% tax on two-third profits).
Second impact is from the Ministry of Finance asking SEBI to evaluate whether a higher public shareholding (at 35% versus 25% currently) made sense in arriving at a superior price discovery. Two of the top three companies (in terms of incremental supply of equity) are in the IT sector. Cumulatively, we reckon that it would lead to incremental supply of INR800b; or an annual supply of INR400b if SEBI gave a two-year glide path.
Points one and two when read together should imply that IT companies go from INR450 annual reduction in float (buy back) to INR400b fresh supply. The combined shift is very large for the markets to absorb, in my opinion.
This comes at a time when IT companies are struggling to maintain margins. Two factors are at play here. One, INR has appreciated versus the USD on an average by 2-3% compared to 4QFY19. In absence of mitigating factors, margins should trend down. Two, US financial institutions are evaluating their overall IT spends (including those on services); BFSI accounts for 30-40% of topline for Indian companies. Lack of profitable growth would put further pressure margins that are already battling adverse currency movement.
Over last 18 months, multiples for IT companies moved higher following INR depreciation, accelerating growth and reducing float. All three are now reversing; and valuation multiples should follow.
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