Reports on IT - Q2FY12 preview: Lackluster quarter by IDFC Sec

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-          Indian IT Services - Q2FY12 preview: Lackluster quarter

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Key takeaways

• Top4 companies: Lackluster revenue growth in an otherwise seasonally strong quarter
• Tier2 companies: Dull revenue growth; modest margin improvement
• Cautious commentary expected in the wake of rising macroeconomic uncertainty
• We remain cautious in the medium-to-long term; Street downgrades expected

With top4 companies expected to report sub-6% qoq USD revenue growth (vs upto 8% in Q1FY12 and 6-12% in Q2FY11), we expect Q2FY12 to be a weak quarter in light of otherwise favorable seasonality. Infosys is likely to lower its FY12 USD revenue growth guidance by 2% (from 18-20% yoy), which will be a key negative underlining the weakness in demand. In our view, Tier-2 companies would report 1-5% USD revenue growth (vs ~5% in Q1FY12 and ~9% in Q2FY11). While INR depreciation (~4% on monthly average basis and ~2% on daily average basis) would be a key margin tailwind for our entire coverage universe in the quarter, we see wage hike-related headwinds for a few. With rising macroeconomic uncertainty, we believe most companies in the sector will incrementally cite caution. We reiterate our Underweight stance on the sector and believe that larger companies like Infosys and TCS are relatively well placed in the current uncertain macroeconomic environment. From the results perspective, we see positive surprises from TCS, HCL Tech and MindTree and negative surprises from Infosys and Persistent Systems.

Top4 companies: Lackluster revenue growth in an otherwise seasonally strong quarter

We expect the top4 IT services companies to report muted results despite the seasonal strength. Sequentially, HCLT, TCS and Infosys are estimated to deliver 5-6% USD revenue growth (vs 10-12% in Q2FY11) and Wipro to report ~4% (vs 6% in Q2FY11). Revenues for all would be volume-driven with some decline in price realization (~70bp cross-currency headwinds). The recent sharp rupee depreciation will be a key margin tailwind for all. Infosys is expected to report the highest margin expansion of ~180bp, followed by ~90bp by TCS (headwinds from promotion related costs). Wipro/ HCL Tech are likely to deliver a margin decline of ~80/120bp due to 2–months/ full quarter wage hike impact respectively.

Tier2 companies: Dull revenue growth; modest margin improvement

Tier2 companies are likely to deliver modest 2-5% qoq revenue growth and ~100bp qoq margin expansion. While most Tier2 companies have significantly lost margins in past 3-4 quarters, margins could expand for Q2FY12 driven by a weaker rupee, operational efficiencies and broadening employee pyramid. Majority of the companies are also expected to witness a decline in attrition rates amidst the macro uncertainties. Key exceptions: MindTree – highest revenue growth in our coverage universe of 8%+; Tech Mahindra – ~150bp margin decline due to impact of wage hike.

Cautious commentary expected in the wake of rising macroeconomic uncertainty

With increased possibility of economic slowdown in the US as well as Euro region, we expect companies to incrementally turn cautious. While we see a few companies reporting instances of delayed decision-making, we do not expect any concrete comments on CY12 tech budgets. We expect Infosys to cut its FY12 USD revenue growth guidance to 16-18% yoy, but raise its INR earnings guidance to factor in a weaker rupee.

We remain cautious in the medium-to-long term; Street downgrades expected

Tech demand typically reacts to economic activity with a lag of a few quarters, and thereby we expect Indian IT services companies to feel the impact of the ongoing economic downturn from the Dec/Mar quarter. We have an Underweight stance on the sector and expect downgrades in Street estimates post Q2FY12 results. In the prevailing scenario, we recommend sticking to larger companies like Infosys and TCS. From the results perspective, we see positive surprises from TCS, HCL Tech and MindTree and negative surprises from Infosys and Persistent Systems.