IT -Demand strong; margin headwind: Q3FY11 Result Preview: Edelweiss

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IT
Demand strong; margin headwind: Q3FY11 Result Preview: Edelweiss


􀂄 Key highlights of the sector during the quarter
Demand environment continued to remain strong during the quarter. Our recent
interaction with companies suggests that barring the impact of fewer working
days during the quarter, performance will be similar to that reported in Q2FY11.
The trend of stable pricing and high attrition seems to have remained unchanged.
While the employee pyramid is likely to be favourable, appreciation of INR vis-àvis
USD and GBP on an average for the quarter will act as a headwind for
margins.

􀂄 Result expectations for the sector and stocks under coverage
We expect volume growth of 5-6% Q-o-Q in Q3FY11 across the board. While
pricing has remained stable, given that the USD has depreciated against the GBP
and EUR, reported pricing is likely to show some uptick. Thus, in USD terms we
expect average revenue growth of 6-7% Q-o-Q.
EBITDA margins are likely to decline in Q3FY11 as utilisation will remain lower Qo-
Q due to fewer working days and as the INR has appreciated against the USD
and GBP. While we expect 60bps Q-o-Q decline in margins for Infosys, Tata
Consultancy Services (TCS) is likely to face a fall of 80bps Q-o-Q also on account
of bad debt provision in Q2FY11. Wipro is likely to report stable margins as in
Q2FY11 their margins had declined 240bps Q-o-Q. HCL Tech (HCLT), in our view,
will report a marginal decline primarily due to INR appreciation and continued
investments in SG&A.
We expect Infosys to surpass its revenue guidance of USD 1,562 mn and report
USD 1,584 mn in Q3FY11. As Infosys’ current EPS guidance of INR 115-117 is
based on an exchange rate of INR 44.5 against the USD and the closing rate for
Q3FY11 is INR 45.1/USD, its EPS guidance is likely to be revised up ~5%.
In mid caps, like in the previous quarter, the December quarter too Infotech and
Hexaware are likely to report 10% and 7% USD growth (partly benefiting from
cross currency movement), respectively. While the former’s EBITDA margins are
likely to improve marginally (50bps), the latter’s are likely to improve 120bps Qo-
Q.
􀂄 Outlook over the next 12 months
We expect management commentary to remain positive during the results
season. We believe, demand remains strong and hence revenue growth is less of
a concern for tier 1 companies. But, given the continued high level of attrition and
competition precluding increase in billing rates, the challenge for the sector is to
defend margins. Companies believe that growth in FY11 was not driven by pent
up demand and hence not one-off, implying that growth could sustain in FY12. We
have revised our FY12 USD revenue growth assumption upwards to 26-30% and
believe the street will also follow suit (currently factoring in 22-24%) for tier 1 IT
companies that will lead to continued stock outperformance.
􀂄 Recommendations
Top picks: Tata Consultancy Services, HCL Tech in large caps.
Infotech in mid caps.