Taking a cue from the staggering September 2006 quarter performance, many information technology stocks, especially the frontline ones, seem to have cheered investors.

The BSE IT index has leapfrogged by 59 per cent zipping past the Sensex, which gained 43 per cent since June, when the markets were at a trough.

Having said this, would you bet on a sector whose valuations of 30 times its trailing 12 month earnings far exceeds that of the Sensex, which trades at 21.73 times?

Analysts have a mixed opinion at the moment. While some continue to be bullish on the sector, all of them emphasise that the future is going to be stock-specific.

They agree that most of the leading stocks have posted a stellar performance in the September 2006 quarter and their guidance for the next few quarters is positive. But there are concerns that valuations are stretched.

Though analysts expect robust demand growth, they are looking for better pricing and margin expansion despite the wage pressure, which is likely to continue as companies scramble for skilled manpower, and that too in large numbers, while attrition rates remain high.

Analysts are biased towards the larger IT companies like Infosys [Get Quote], TCS [Get Quote], Wipro [Get Quote] and Satyam [Get Quote], as they will be able to deal with any possible shock better than their smaller counterparts. Most domestic and foreign brokerage firms maintain a 'Buy' on the sector.

Says Manoj Shroff, analyst Parag Parikh Financial Advisory Services, "While large caps are expected to continue their robust growth trend, which is to an extent built in the price on FY07 basis, however they look fairly attractive on FY08 basis."

So far, so good

Almost all the companies, big or small, that have announced their results, have exceeded analysts' expectations.

While robust volume growth of around 10 per cent, modest price rise of about 1 per cent and rupee depreciation in the September 2006 quarter (2 per cent, 5 per cent and about 4 per cent against the dollar, pound and euro respectively) have led to the strong rise in the top line, higher operating expenses, especially employee costs, has led to margin crunch for most of them.

Infosys undoubtedly has led the pack outperforming its peers on all parameters followed by TCS. However, how sustainable are these growth rates?

As far as demand growth is concerned, there is a clear visibility for top line growth of Indian companies not only in case of the traditional business of IT services, but also in business like BPO and package implementation. A rise in the US corporate profits in the first half of 2006 suggests that IT spending will continue to rise.

According to IDC estimates, global IT services spend will grow at a 5.7 per cent CAGR in 2005-10 to $589 billion with offshore IT services growing faster. NASSCOM-Mckinsey forecasts that Indian IT-BPO exports will grow at 25 per cent in the same period, with India leading with a 50 per cent share.

Thus, volumes are expected to continue growing. Staffing these volumes too is not likely to be a problem in the near-term. Software companies have recruited large numbers in the past year or so, and utilisation rates, which had declined to 72 per cent in the December 2005 quarter, can go up to 400-500 basis points, say analysts.

However analysts feel that the volume growth seems to have been factored into the stock prices. Going forward, what could positively impact the movement of stocks is the price increase and improvement in operating profit margins.

As the large Indian tech companies get larger, the order size is also becoming big. Companies are looking to large multi-year, multi-million-dollar contracts to improve growth.

While these orders are large, there will be pricing pressure on such deals. As a result, some foreign brokerage firms expect limited pricing power due to large deals. Another sign to watch for is the slowdown in the US.

But the guidance from tech companies suggests that they are witnessing better pricing negotiability. They expect a 3-5 per cent rise from new contracts, although these form a very small share (around 10 per cent) of overall revenues.

Also, as more work moves offshore, average billing rates will improve. A higher proportion of value-added services will also improve pricing. Does all this mean that margins will better?

Margins to be flat or decline a bit

Analysts expect operating profit margins of companies to decline gradually over time as international majors like IBM Global, Accenture and EDS will increase their size, resulting in wage pressure for software professionals.

Analysts are unanimous in their expectation that despite better pricing and cost efficiencies, margins will reduce. Salaries form 80-85 per cent of costs and about 50 per cent of revenues of Indian IT companies on an average. And they have been steadily on the rise year on year.

Also, higher tax rates is also going to be an additional burden on the bottom line of companies going ahead. The industry will lose tax benefits under Section 10A/10B on 31st March 2009. So companies will gradually move to 33 per cent effective tax rates from the current 13-16 per cent.

However, with most of the incremental expansion in the sector coming through Special Economic Zones, which have full tax benefits until 2014, the effective tax rate would move up only marginally over the next few years.

In order to protect margins, companies are adopting various measures like cost efficiencies, change in the employee mix tilted towards more fresh graduates or lesser experienced people and even acquisitions to enter new businesses or new geographies, increase scale of business and be globally competitive. In a nutshell, price and margins will be the key driver for future stock price movements.

Impact of US slowdown

Since almost 70 per cent of Indian IT services exports are to the US, which is showing signs of slowing down, will the breakneck speed of IT companies' growth come to a screeching halt?

Most analysts rule out fears of the impact of slowdown in the US given India's cost competitiveness (Costs in India are one-sixth of that of US), value addition and diversification in new services like consulting, testing and infrastructure.

Says Anurag Purohit, analyst, BRICS PCG, "Companies in the developed market would look at outsourcing more work to cost competitive countries like India to leverage on costs and maintain the return on investment in case of a US slowdown."

However, leading foreign brokerage firms feel that the slowdown in the US cannot be ignored and will pull down the overall IT spending. The risk becomes large only in case of a hard landing of the US economy, though the probability of such an eventuality appears low right now.

Moreover, companies are increasingly reducing dependence on US as demand from other regions, mainly Europe, has been gathering pace. European business, though a small portion of the total revenues, is rising faster than the total revenues for most IT companies.

In terms of stocks, analysts prefer large companies because of their geographical reach, pricing power, employee management and ability to sustain margins.

Infosys: This stock has gained the most in terms of price appreciation. With the highest top line and operating profit growth followed with an improvement in operating margins, most analysts feel that it is the best stock despite stretched valuations.

"Infosys is a total organic growth story and hence the safest bet," says Purohit. The company raised its EPS guidance for this fiscal once again by about 6 per cent to Rs 66 in September 2006 quarter translating to a growth of 47 per cent y-o-y.

TCS: TCS is trading at a lower valuation relative to Infosys, despite being India's largest IT services player. This is partially due to lower growth rate and operating margins as compared with Infosys. However, the company makes a sound investment for its robust business model and management quality.

Wipro: In September 2006 quarter, though the company reported strong top line growth, operating margins were a tad lower on a sequential basis.

Analsyts see limited upside in the stock price saying that larger players with much higher growth rates are quoting at similar valuations.

However, the company cannot be ignored just on the basis on valuations as it has the third largest Indian IT services operations, the largest third-party BPO operation in India and is also the largest third-party R&D services provider globally.

Satyam: Satyam posted subdued September 2006 quarter performance as it witnessed pricing pressure marginally and its margins declined thanks to an aggressive salary hike.