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Software
Broad-based growth continues to cheer the IT pack
The aggregate US macro data for November 2010 points
towards a sustained recovery going ahead. The positive cues
for November 2010 include 1) capacity utilisation firming up
to 75.2% v/s 74.9% in October 2010; 2) industrial production
holding at 5.4% v/s 5.5% in October 2010; 3) retail sales
continuing to grow at 7.7% yoy in November 2010; 4) personal
income growth sustaining the momentum of 3.8% yoy; and 5)
durable goods order growth expanding to 10.4% yoy
v/s 9.3% yoy in October 2010. Also, in December 2010, the
US PMI expanded to 57.0 from 56.6 in November 2010. In
fact, even Europe's macro data strengthened with PMI shooting
to 58.0 in November 2010 from 55.4 in October 2010. The
change in the perception about recovery being sustainable from
the earlier perception of it being just a fad (in 2QFY2011) and
the continued spending on IT by global corporates led to the
outperformance of IT stocks over the BSE Sensex, although clients
are going in for short-term spending commitment rather than
long-term commitment. For CY2011, managements of tier-I IT
companies expect client budgets to remain flat to positive, with
a higher element of offshoring.
For 3QFY2011, we expect growth to continue to be
broad-based with the BFSI and retail segments leading the
growth path and the manufacturing segment following their
footsteps; however, the telecom segment will continue to be
laggard.
The recent increase in IT spending in the BFSI segment (the
major contributor with 45-50% to exports) is driven by business
needs related to 1) regulatory compliance and risk,
2) rationalisation and consolidation and 3) post-merger
integration. The next wave of strategic investment by BFSI clients
is expected in areas of 1) mobility 2) social commerce and
3) risk and compliance. For the retail segment, IT spend
continues to grow in order to tap the digital consumer's behavior,
social media and multi-channel commerce.
The hi-tech and manufacturing segments are also back to their
secular growth phase, but spending in telecom continues to be
a laggard though telecom service providers (TSPs) in the
emerging markets are investing in expansion and roll outs.
Geographically, US is ahead, riding on the wave of technological
investments to drive growth apart from harvesting cost
efficiencies, whereas European clients, especially in continental
Europe, are opening up to outsourcing-offshoring to drive cost
efficiencies. This is leading to the rise of transformational deals
with a higher component of discretionary services such as
enterprise application services (EAS) and engineering, research
and development (ERD) from the manufacturing, utilities and
retail segments.
In case of EAS, incremental growth is emerging out of
implementation work rather than sale of new licenses. In fact,
the need for standardisation of enterprise platforms, i.e.
conversion of multi-version implementation into single-version
or limited-version as well as global-level rollout of the same is
pacing up. Even ERD services are witnessing a spurt in demand,
with product companies getting aggressive and trying to launch
a series of new products by shortening the go-to-market cycle.
Thus, the surge in discretionary spending witnessed in
2QFY2011 continues its traction as more and more clients look
at change-the-business initiatives via IT spending as a growth
driver and cost optimiser.
Cross-currency movement continues to favour revenue
The cross-currency movement, which had proved to be the bane
over 4QFY2010-1QFY2011 impacting USD revenue by
0.8-1.5% (qoq), has turned into a boon since 2QFY2011. The
USD depreciated by 1.9%, 5.1% and 9.1% against the GBP,
Euro and AUD to 1.58, 1.36 and 0.99, respectively, in
3QFY2011. This will aid USD revenue for Infosys, TCS, Wipro
and HCL Tech by 1.3%, 0.7%, 1.1% and 1.7%, respectively.
Although, gains from weaker USD against global currencies
will be wiped off due to the INR appreciating steeply against
the USD by 3.5% qoq in 3QFY2011.
Hiring spree to continue
IT players got into the hiring mode from 3QFY2010, with high
lateral hiring in 2HFY2010 to tap the sudden pent-up demand.
With an improving demand landscape, Infosys and TCS have
increased their hiring targets for FY2011 by over 10% and 20%,
respectively, over the past two quarters. Companies are now
looking at planned hiring to address the strengthening demand
pipeline. We expect the hiring trend to remain upbeat, with
Infosys expected to have hired ~7,268 employees and TCS
hiring ~13,837 employees in 3QFY2011.
Utilisation to be a mixed bag
Utilisation levels for TCS and Infosys peaked in 2QFY2011,
reporting historic high of 77.7% and 74.3% (including trainees),
respectively. For HCL Tech and Wipro, due to strong fresher
hiring, utilisation level did not expand but remained lower than
that in 1QFY2011. In 3QFY2011, we expect utilisations for
TCS to come off, but expect them to remain firm for Infosys and
HCL Tech as trainees hired in 1HFY2011 will start getting billed.
For Wipro, we expect better utilisations in 3QFY2011.
Attrition to cool off
Attrition levels had shot up in 2QFY2011 to the pre-recessionary
levels of FY2008, as companies were flocking for people
everywhere to map the sudden surge in demand. However,
going forward, we expect these rates to normalise as strong
campus hiring carried out simultaneously by these companies
will create a stable bench, which will help them to map any
surge in demand and thus, abate poaching of laterals. Thus,
we do not expect attrition to be a spoilsport anymore, causing
any lapse in the billable position of companies.
Cyclically a weak quarter but with strong volume growth
Traditionally, 3Q is a weak quarter for IT companies as the
number of working days is less, compared to the other quarters,
due to the holiday season at the client site. However, for
3QFY2011, on the back of continued IT spend by clients, we
expect volume growth to remain strong at 5.6-7.1% qoq for
tier-I companies, even on the base of high volume growth of
6.6-11.2% qoq witnessed in 2QFY2011.
Surge in revenue to continue
In 3QFY2011, on the back of strong volume growth, stable
pricing and favourable cross-currency movement, we expect
USD revenue to surge by 6.0-8.7% qoq for tier-I IT companies.
This growth will be lower in INR terms at 3.1-5.1% qoq due to
INR being stronger in 3QFY2011, at 44.85 v/s 46.48 (in
2QFY2011).
Margins to be a mixed bag
We expect Infosys to record a dip of 78bp qoq in its EBIT margins
due to the impact of mid-year promotion in October 2010 and
3.4% appreciation in INR against USD. In case of TCS, the drop
in utilisations and INR appreciation are expected to take away
productivity gains. Wipro is expected to record a 110bp qoq
expansion in EBIT margins for the IT services segment on the
back of better utilisations qoq; however, at a consolidated level,
Wipro is expected to record only 81bp qoq expansion due to
good growth in the IT products segment, which is a thin-margin
business. HCL Tech is expected to record a 30bp qoq expansion
in its EBIT margins on the back of strong cross-currency benefit
and productivity gains. Thus, for 3QFY2011, tier-I IT companies
are expected to report a mixed bag performance on the EBIT
margin front.
Outlook and valuation
Over the last three quarters, there is an uptick in discretionary
spending as clients are looking forward to gain competitive
advantage by remaining ahead of the curve. This trend, though
led by the BFSI and retail segments and largely driven by the
US market, is expected to be more broad-based with broader
economies tracking recovery in the true sense, thereby instilling
confidence in the IT sector. Thus, we expect 3QFY2011 to be
yet again a strong quarter with 6.0-8.7% qoq growth in USD
revenue for tier-I IT companies, aided by buoyant demand
driving volumes, favourable cross-currency movement and
stable pricing environment. Moreover, we expect Infosys to revise
its revenue growth guidance upwards from 24-25% yoy to
27-28% yoy for FY2011. We remain positive on the IT sector
with TCS, Infosys and HCL Tech as our preferred picks.
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