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INFORMATION TECHNOLOGY
We expect companies under our coverage to report a sequential revenue
growth of 2.4%, largely driven by volumes. Volumes for the Top 4
companies are expected to rise by 5% - 8%, which is impressive in the
backdrop of a seasonally soft quarter. Average realizations are expected to
remain stable. While cross currency volatility should help, the appreciation
of rupee v/s USD and GBP should set off those gains.
EBIDTA margins are expected to be marginally lower as cost efficiencies
and scale benefits nullify the impact of rupee appreciation. With the
quarter - end rupee / USD exchange rate being almost at the 2QFY11 end
levels, we expect minor forex losses / gains for the quarter. The average
rate is also very near to the 2QFY11 end rate.
Consequently, PAT is expected to rise by 3.5% QoQ for companies under
our coverage. Among the Top 4, HCLT is expected to report the highest
QoQ PAT growth of about 12%. We have given quarterly expectations of
Mahindra Satyam but understand that, the numbers can be materially
different from our expectations.
The guidance from Infosys will be more important this time, with markets
already discounting high growth rates for FY11 as well as FY12. The
accompanying commentary will allow us to gauge the confidence of the
management on expected medium - term growth rates and measures to
check supply side pressures.
We expect the guidance to be revised up on the back of a supportive macro
scenario. However, the 4Q growth guidance may be conservative due to
lack of complete information on CY11 client spending budgets, rupee
appreciation and the still hazy scenario in Europe.
Attrition issues, especially with mid cap companies will also be a point of
focus for us. While we remain optimistic on the medium-to-long term
prospects of the sector, relatively high valuations and a stronger rupee may
limit upsides in the near term. We expect large caps to out-perform as they
are better equipped to counter the impact of appreciating rupee, high
attrition and any potential economic slowdown globally. Infosys and TCS
remain our preferred large-cap picks. In mid-caps, we prefer NIIT
Technologies and KPIT Cummins. Mphasis is not covered here because
quarter ends in January.
5% - 8% sequential volume growth expected for top tier companies
We expect top-tier companies to report sustained volume growth of about 5% -
8% QoQ. When seen in the backdrop of a seasonally soft quarter, it is encouraging.
The expected growth is on the back of consistently improving demand and
higher market share. We understand that, Indian companies have been witnessing
continuous business flows as customers look for better value and reduced costs. In
this process, they are likely gaining additional market share.
Over the past few quarters, M&A activity in the global BFSI vertical had resulted in
increased business flows. This is now being substituted by more long term and annuity
type of businesses, we believe. Moreover, verticals like manufacturing, which
were slower to start spending, are now seeing increased deal flows, we understand.
However, management comments on the potential trends in manufacturing will be
important. The recent economic data in the developed economies may have an important
bearing on these spends in the quarters going ahead.
While the order flows from US are expected to have grown, we also believe that
the same from Europe have not witnessed any major uptick during the quarter.
However, we will closely hear management comments on the potential order flows
from that geography.
While volumes are expected to rise QoQ, we expect realizations to be largely stable.
Impact of cross currency movements
The USD has depreciated against the Euro and GBP by about 5.25% and 1.9%,
respectively. This is expected to help sequential revenue growth (in USD terms) for
companies, depending on the proportion of revenues earned in these currencies.
On an average, the INR has, however, appreciated against USD (3.5%) and GBP
(1.7%) while depreciated v/s the Euro (1.6%). This is expected to nullify some of
the benefits accruing from the cross currency movements. The overall impact of
currency movements should result in about 2% loss in revenues for the Top 3 companies.
However, the impact on the net income may vary depending on the extent of
hedging done by various companies.
For the Top 4 companies, we expect revenues to be about 2.9% higher in INR
terms. For the coverage universe, we expect the INR revenues to be at about 2.4%
higher QoQ.
Margins expected to be slightly lower
We expect margins to be slightly lower sequentially. Rupee appreciation is expected
to off-set any benefit accruing from cost efficiencies and scale. Within the Top 4,
Infosys is expected to report a slight improvement due to higher utilization levels
and cost efficiencies.
Translation losses
The average INR / USD exchange rate (44.86) and also the closing rate (44.85) are
almost at the 2QFY11 closing levels (44.95). To that extent, we expect marginal
forex gains / losses for the quarter.
Consequently, PAT growth is expected to grow by about 3.5% over the previous
quarter.
Factors to watch
Apart from Infosys' guidance, we will closely track i) optimism of various company
managements on near and medium term growth rates, ii) initial feedback on client
IT budgets for CY11, Iii) signs of increases in realizations, iv) attrition and v) employee
hiring plans. Comments on opening up of discretionary spends and spends
in manufacturing sector will also be of interest to us.
While we expect Infosys to revise its FY11 guidance, the extent of revision will be
important. We expect Infosys' management to give due weightage to rupee appreciation,
pending conclusion of client surveys and the still uncertain situation in developed
economies. We note that, consensus estimates (including our estimates)
are significantly higher than the company guidance and the guidance revision will
be important for sustaining sentiments.
Management optimism on the medium term outlook, if any, will help in sustaining
the already positive sentiments on the sector. Pricing is expected to have largely stabilized
during the quarter and we will watch out for comments on any potential
pricing uptick from clients. TCS had indicated that, pricing might pick up in
2HFY11.
Attrition was high in 1QFY11 and 2QFY11 across companies, though it had moderated
in 2Q. We will watch out for the attrition rates. While we expect attrition rates
at larger companies to have moderated, the same is expected to have remained
high for mid caps. Net addition of employees (campus and laterals) would imply
better revenue visibility and more comfort on costs for companies.
Remain positive on medium-to-long term prospects, but cautious
on near term valuations
We maintain our positive bias on sector fundamentals over the medium-to-long
term. A slow recovery in the global economy should reflect in increased business
for Indian IT vendors. Indian companies have likely been able to increase their market
share in the global outsourcing pie.
However, the run up in prices during the October - December quarter may limit the
upsides in the near term. If the rupee strengthens over an extended period of time,
it may impact earnings estimates for most companies. Larger companies are betterequipped
to handle the appreciating rupee, we admit.
We prefer Infosys and TCS in the large caps. NIIT Technologies and KPIT Cummins
are the preferred mid cap stocks. We have not covered the estimates for Mphasis
because its quarter ending will be in January.
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