September quarter results are likely to endorse the market share gain thesis for the Indian IT. While MNC vendors defend their turf in large deals, the offshoring proposition along with domain expertise of large Indian vendors is resulting in the latter wining ~30% of deals renewed in a year. Overall, the offshore outsourcing story has once again gained steam post the downturn.
n Result expectations for the sector and stocks under coverage
We expect yet another strong quarter from the tier-1 companies with healthy 7-8% USD revenue growth (8-10% INR terms) over the previous quarter. Demand recovery, earlier driven by pent up demand, is now supported by revival of spend focused towards revenue strategies (discretionary) that will lead to this sustained strong growth. Changing nature of spend in BFSI vertical, full services deals being awarded and furtherance to infrastructure outsourcing initiative, are all driving growth. Also, as evinced from the recent Accenture results, demand for outsourcing is strong leading to stronger built up of its outsourcing order book.
Margins to be a mixed bag: With strong growth in business volumes, operating margins are expected to increase with Infosys leading the Q-o-Q increase of 160bps (from lower base). TCS and Wipro, face margin headwind from promotions, while benefit from currency and high volume growth will partly offset the margin pressure. Margins for HCLT, due to salary increases are expected to decline 260bps Q-o-Q.
Infosys’ guidance: We see Infosys surpassing its Q2FY11 revenue guidance (5.1% growth) with ease, and expect the full year FY11 USD revenue guidance to be raised by 2% to 21-23%. However, as the company rebases its INR/USD assumption to ~44.95 from 46.45, we see ~3% negative impact on EPS (INR terms). But the outperformance vis-à-vis guidance in Q2 and improved outlook for the remaining year will lead to INR EPS guidance being marginally upped at ~INR 119. Guidance for Q3FY11 revenue growth is expected at 5%.
Selective mid-caps to report strong growth: We expect tier-2 companies to report strong sequential growth that comes after a lag of few quarters to tier-1 companies. This is expected to be driven largely by existing large client ramp up. We expect double-digit revenue growth for Infotech & Hexaware and 1.8% & 1.3% improvement in EBITDA margins, Q-o-Q, respectively.
n Outlook over the next 12 months
Strong demand environment over short term reinforces our confidence on increased visibility for FY12. However, companies may be cautious about growth going into FY12, given slowing global growth and low visibility of CY11 client budgets. With stock prices at 20-22x FY12 earnings for tier-1 stocks, we believe upward re-rating is unlikely though earnings upgrade will provide further stock returns. On the other hand, we expect tier-2 companies with improvement in revenue growth and increase in operating margins to see some upward valuation re-rating. Current P/E and EV/EBITDA discount of tier-2 to tier-1 companies stand at 50% and 60%, respectively, which we expect to reduce in the next six months.
n Top picks: Large caps - TCS and HCLT; Mid caps - Infotech and Hexaware
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