Wipro: Pare down exposures

Recommendation:Pare down exposures

Suresh Krishnamurthy

FRESH investments need not be contemplated in the stock of Wipro. The stock trades at a price-to-earnings multiple of 30 times its earnings for the 12 month period ended September 2001.

Despite the sharp decline in stock price in recent times, the stock continues to remain relatively over-valued vis-a-vis its peers. The gap in valuation between Wipro and its peers has, however, narrowed in recent times.

The higher valuation that the stock has commanded historically is partly due to expectations that Wipro's per share earnings would grow at a higher rate compared to its frontline peers. However, the financial performance for the second quarter ended September 2001 has cast a doubt on Wipro's ability to generate substantial out performance over its peers is unlikely. In this backdrop, a decline in valuation multiples of Wipro can be expected.

On the other hand, Wipro's present valuation demands average growth rates of 15-20 per cent over the medium term. While this appears modest and achievable, the uncertainty enveloping the software export scenario renders predictions beyond the next quarter speculative. This creates a bias against holding positions with a longer-term perspective.

As such, investors can pare down their exposures now with a view to taking positions later when the valuations of Wipro are in line with that of its peers. The company continues to remain fundamentally strong and is likely to be one of the companies that is likely to perform well in the industry over the medium-term.

Suitability: For an investor with a portfolio of IT stocks, exposure to Wipro can be reduced and exposures can be enhanced in some of its under-valued peers. However, it may prudent to maintain the overall exposure to IT stocks at 12 per cent, which is its weight in the index. A higher proportion enhances the risk of the portfolio.

Higher valuation: The premium valuation commanded by Wipro compared to its peers can be related to two factors. One is the expected growth rate of Wipro and the other is the quality of services rendered by Wipro. Wipro has steadfastly remained focussed on high value-added services rather than compete for low value-added services.

This focus may have been expected to help Wipro offset any decline in revenues due to a slowdown. However, in a scenario where investments in technology continue to remain under pressure, the focus on value-added services rendered by Wipro might have even contributed to the pressure on revenue growth.

Wipro has a hurdle rate of return, below which it will not accept projects. In short, Wipro would sacrifice revenue growth if it were not profitable enough. This focus helped Wipro's revenues to grow without affecting its margins. Now, however, the market forces are testing the strategy. On its part, Wipro expects to benefit over the medium-term because of the unrelenting focus on value-added services. Inherent is the assumption that the slowdown is temporary and the trend of growing revenues would resume in the next few quarters.

Performance: Wipro's financial performance for the second quarter ended September 2001 signals that the slowdown in the software exports has begun to have its effect on Wipro. Revenues from Global IT services have remained virtually stagnant with a growth of less than 1 per cent over the quarter ended June 2001. Only the contribution of low value-added products has enabled Wipro show a growth in exports of 10 per cent over the quarter ended June 2001.

In addition, the margins in the Global IT services business have also declined. Overall, the sluggish revenue growth combined with lower margins led to a decline in gross profits from the Global IT services and products business in the quarter ended September 2001 compared to the earlier quarter.

The major reason for the decline in margins appears to be the lower utilisation of manpower. According to Wipro, utilisation rate fell 7 per cent compared to the quarter ended September 2000.

In the quarter ended June too, manpower utilisation had declined by 11 per cent. Overall, the impact had been to pull down the margins. The rise in billing rates appears to have compensated for the costs of lower utilisation but only partly.

Profit growth of 11.7 per cent over the previous quarter has come from reduction in selling, general and administrative expenses and gains from the depreciation of the rupee. Overall, the growth in profit from these sources other than top line growth or margin expansion is a cause for concern.

However, the performance on the cash flow front is impressive. Compared to June 2001, accounts receivable has declined while cash flow from operations have nearly doubled.

Outlook: Wipro has indicated that Global IT services revenues may rise by 5 per cent over the quarter ended September 2001. In the backdrop of the large projects secured by Wipro in recent times, the growth of 5 per cent appears achievable.

However, what is important is where the growth would come from. If, as in the quarter ended September 2001, growth comes from product revenues, the pressure on profit margins would continue to exist.

On the other hand, if Wipro is able to generate increases in billing rates, the pressures would be offset partly. Overall, the prevailing set of circumstances does not leave room for optimism in the near term.

Another factor is the impact of the slowdown in the economy on the India and Asia IT services and products segment. Indeed, the contribution of the Global IT services is more than 93 per cent of the total operating profit of Wipro. However, any sharp slowdown in the Indian and Asian market for products can accentuate the pressure on profitability.In terms of valuation, the performance in the second quarter may lead to price weakness in the short term. Any significant decline in the valuation of the stock to the levels of its peers can be used to increase exposures to the stock.