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Demand landscape remains unscathed
The demand environment cited by most tier-I IT companies in
terms of 1) positive client budgets for CY2011 across industries
(expect telecom, which is expected to be flat) and with a higher
component of offshoring; 2) like-to-like pricing increase in some
of the deals as well as clients willing to compensate for cost of
living adjustment (COLA); 3) upbeat gross hiring guidance for
FY2012 by Infosys and TCS of 45,000 and 60,000, respectively;
4) robust revenue growth guidance by Infosys (18-20% yoy)
and Cognizant (at least 29% yoy); 5) global major Accenture
(August year ending) raising revenue growth guidance from
8-11% yoy in 1QFY2011 to 11-14% yoy in 2QFY2011 and
then to 14-15% yoy in 3QFY2011; and 6) uptick in new license
sales by Oracle envisage a strong demand environment for
IT spending.
Budgets persist but looming macro concerns cause delay
The aggregate US macro data for May 2011 highlights looming
concerns about the macro picture, with data points like
1) manufacturing index declining to 53.5 vs. 60.4 for April 2011,
2) retail sales growth dropping to -0.2% vs. 0.3% for April 2011,
3) consumer confidence decreasing to 60.8 from 66.0 for April
2011 and 4) US GDP at 1.8% for 1QCY2012 as against 3.1%
for 4QFY2011. For Europe, the PMI index declined to 54.6 for
May 2011 from 58.0 for April 2011.
Client budgets are positive on a yoy basis. However, due to
unstable macros, the pent-up in budget flush is not happening
as planned because clients are turning marginally cautious
towards economic recovery. However, there are no indications
of any budget cuts from clients and IT companies continue to
see robust demand for discretionary services going ahead.
In fact, Gartner has recently increased its estimate of IT spending
for CY2011 to 7.1% yoy from 5.6% yoy earlier.
IT index has underperformed over the past three months,
as 4QFY2011 panned out to be a soft quarter because of clients
freezing their budgeting cycles. However, the demand outlook
for IT spending remains positive as clients look forward to spend
on discretionary services such as enterprise solutions and
engineering services to drive cost efficiency, prepare for growth
and capture market share.
For the retail and CPG segment, IT spend continues to grow on
multi-channel integration to encash on the digital consumer
behaviour. Also, retail clients are spending on digital marketing
and mobile and social technology to provide multi-channel
experience, retail commerce and mobile marketing to increase
digital consumer engagements.
The manufacturing segment is also back with higher spend on
IT, especially with industries such as hi-tech and semiconductor
looking at immediate go-to-market strategies and, thus,
spending on product engineering, supply-chain management
and consulting to drive cost efficiencies. In the manufacturing
segment, automotive and aerospace have also started spending
on dealer management network, CRM applications, rationalising
internal processes, setting up shared services, global launch
and product engineering.
Spending continues to be broad-based (ex. telecom)
For 1QFY2012, we expect demand drivers for growth to
continue to span across various dimensions – industry wise
(except telecom, which will continue to be sluggish), service wise
and geography wise. As per NASSCOM's strategic review in
February 2011, worldwide IT spend is expected to grow by ~4%
in CY2011.
Industry-wise trends: The BFSI segment (the major contributor
with a 45-50% share in exports) will continue to lead in terms
of volume due to persistent work related to 1) regulatory
compliance, 2) data analytics, 3) operational efficiency and
4) risk and fraud prevention
The energy and utilities vertical is gaining strong traction,
especially for businesses relating to oil and gas, smart grid and
safety, among others, mostly for cost-cutting measures.
The telecom vertical is still a very soft spender and client budgets
remain weak. This vertical was heavily impacted for Infosys and
TCS due to one of their top clients, British Telecom, cutting back
heavily on capex and downsizing operations. Managements of
both the companies maintain that the client-specific issue is
behind, and they foresee a slow recovery in the sector. We believe
TSPs of matured markets will start spending to migrate to
next-generation networks such as 4G to support the heavy voice
and burgeoning data traffic.
Service-wise trends: Changed business needs of various
industries have led to a surge in demand for discretionary
services such as enterprise application services (EAS) and
engineering and R&D (ERD) services. Investments in EAS mostly
focus on simplifying internal processes and harmonising
business processes across the enterprise to make organisations
smarter and leaner – primarily focusing on increasing efficiencies
and reducing throughput. 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. In addition, demand for ERD services is
driven by increasing use of electronics, fuel efficiency norms,
convergence of local markets and localised products.
Hiring spree to continue
IT players got into the hiring mode from 2HFY2010, with high
lateral hiring to tap the sudden increase in demand. With a
strengthening demand landscape, Infosys and TCS have
indicated robust gross hiring targets yet again for FY2012 of
45,000 and 60,000, even on the total employee base of
1,30,820 and 1, 99,365, respectively. These initial hiring
numbers are much higher than the initial hiring numbers of
30,000 each indicated a year ago by Infosys and TCS. Also,
due to the unanticipated pent-up demand as well as higher
attrition rates of 20-25% annualised, gross hiring numbers for
FY2011 stood much higher at 43,120 and 69,685 for Infosys
and TCS, respectively.
Companies are now looking at planned hiring to address the
strengthening demand pipeline as well as to flatten their
employee pyramids. Infosys and TCS have planned to give
campus offers to 27,500 and 37,000 people (most of which
have already been given), respectively, indicating that majority
of the hiring in FY2012 will be of freshers. Also, with cooling
attrition rates, we do not expect attrition to be a spoilsport
anymore as companies resort back to planned hiring. We expect
the hiring trend to remain upbeat, with Infosys expected to have
hired ~6,921 employees and TCS hiring ~8,901 employees
in 1QFY2012.
Utilisation to be a mixed bag
In 1QFY2012, we expect the utilisation level (including trainees)
of Infosys to marginally increase by 50bp qoq to 68.9%.
In case of TCS, we expect the company to hold up (qoq) its
utilisation level (including trainees) at 75.1%. Wipro and
HCL Tech, on the other hand, are expected to see a marginal
dip of 30bp and 40bp qoq to 75.8% and 76.9% in their
utilisation level, respectively, on the back of freshers joining in.
Cross-currency movement to favour dollar revenue growth
The cross-currency movement, which had proved to be a bane
over 4QFY2010-1QFY2011 impacting USD revenue by
0.8-1.5% (qoq), has turned into a boon since 2QFY2011.
The USD has depreciated by 5.2%, 1.8% and 5.7% qoq against
the Euro, GBP and AUD, respectively, in 1QFY2012. This will
aid USD revenue for Infosys, TCS, Wipro and HCL Tech by 1.3%,
0.8%, 1.1% and 1.4%, respectively. In the entire IT pack,
Tech Mahindra is expected to be the highest beneficiary of
favourable cross-currency movement of 2% qoq. However,
INR has appreciated by 1.2% qoq against USD in 1QFY2012,
which will result in lower rupee revenue growth vs. dollar revenue
growth and impact operating margins by 35-40bp.
Modest volume growth
Traditionally, 1Q is a strong quarter for IT companies as client
budgets on the kind of discretionary, operational and capital
spending freeze by 4Q and budget flush start happening in the
next quarter. However, we expect 1QFY2012 to be modest in
terms of volume growth due to unstable macros because of
which clients are delaying the incremental budget flush from
their end. For 1QFY2012, we expect volume growth to remain
modest at 0-4.8% qoq for tier-I IT companies.
Revenue continues to surge
For 1QFY2012, we expect USD revenue to surge by 1.1-6.2%
qoq for tier-I IT companies on the back of modest volume growth,
stable pricing and favourable cross-currency movement. In INR
terms, revenue growth is expected to be lower at 0.4-4.7% qoq
due to appreciation of INR against USD on a qoq basis
Margins to decline due to annual wage hikes
We expect EBIT margin for Infosys, TCS and Wipro to decline
on the back of wage hikes given in 1QFY2012. Also,
appreciating rupee remains a challenge. Infosys and TCS are
expected to record a margin decline of 270bp and 228bp qoq
to 26.3% and 25.7%, respectively. Impact on the EBIT margin
of Wipro's IT services segment due to wage hike will be less at
49bp to 21.6% as the increment is effective from June 1, 2011,
so the major impact will flow in 2QFY2012. On a consolidated
level, Wipro's EBIT margin is expected to be flat qoq at 17.8%.
For HCL Tech, we expect the company's EBIT margin to improve
by 120bp qoq to 15.6% due to operating leverage on the back
of higher volume growth. In case of TechMahindra, we expect
the margin to expand by 213bp qoq due to SGA efficiency,
growth in non-BT and absence of wage hikes.
Earnings to slip (ex. HCL Tech)
On the back of wage hikes undertaken in 1QFY2012,
profitability of tier-I companies like TCS and Infosys is expected
to slip by 7% and 9% qoq, respectively. For Wipro, the impact
will be limited to a 1% qoq decline due to partial impact of the
wage hike. However, for HCL Tech profitability is expected to
scorch up on the back of margin expansion and nil forex loss.
Amongst mid-tier IT companies, profitability is expected to slide
steeply on the back of wage hike as well as shooting up of tax
rates because of the expiry of STPI w.e.f. April 1, 2011. However,
this was already priced in our estimates.
Outlook and valuation
The global macro data is pointing towards a bleak outlook for
global corporate profits, though currently S&P 500 quarterly
profits are about to tick in a lifetime high. Clients have allocated
2-3% higher budgets related to IT spending in CY2011,
but some delay in spending is surfacing as they are turning a
bit cautious on the back of tepid macro indicators. Therefore,
1QFY2012 is expected to be modest at 1.1-6.2% qoq growth
in USD revenue for tier-I IT companies, aided by moderate
demand driving volumes, favourable cross-currency movement
and stable pricing environment. However, due to looming macro
concerns, coutiousness prevails for CY2012 client budgets.
We remain cautiously optimistic on the IT sector with TCS, Infosys
and HCL Tech as our preferred picks.
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