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IT sector earnings preview: Revenue growth seen as pricing pressures ease

Surya R Kannoth
ET Bureau
Thursday, October 8, 2009

MUMBAI: IT bellwether Infosys Technologies’ quarterly results declaration on Friday will officially kickstart the earnings season for the

June-September period. Market watchers believe that India Inc may report a fall in quarterly profits on an annual basis but the road ahead looks better with the economy back on recovery track.

The technology sector, in particular, could post a rise in revenues as the global economic climate is improving and pricing pressures ease for US-based clients.

“Management of front-line information technology companies have commented positively on the demand environment. Tata Consultancy Services’ management has hinted towards some signs of recovery in outsourcing demand especially from the banking, financial services and insurance (BFSI) vertical. It said that the banking and finance industry across the globe is beginning to have a re-look at discretionary spend that was frozen completely after the financial meltdown. This would benefit players such as TCS and Infosys Technologies that have relatively higher exposure to the BFSI vertical,” said brokerage firm Sharekhan in an earnings preview note.

Improved demand environment has led to improved decision making cycle and deal closures have started taking place. In fact, front-line IT companies have been benefiting from vendor consolidation scheme. Based on deals reported in media, there has been deal flow of US$2.2 billion for IT vendors in Q2FY2010. Improved decision-making cycle coupled with the pent-up demand bodes well for CY2010 IT budgets. The same also improves the revenue visibility of front-line IT companies.

There has been increased news flow for wage hike review by front-line IT companies. The brokerage feels that while the wage hike review provides confidence for improving the business environment, this can have negative impact on the margins of frontline IT firms. “We believe, players such as Infosys and TCS with lower utilisation rate will be in better position to manage their margins going forward,” the brokerage firm added.

The brokerage has fine-tuned its FY2010 and FY2011 earnings estimates marginally for front-line IT companies. “We are upgrading TCS to Buy recommendation on the back of better earnings compounded annual growth rate (CAGR) during FY2009-11 than its peers, the recovery in BFSI vertical, lower utilisation rate providing layer for margin management and healthy deal pipeline. We maintain our Hold recommendation on other frontline IT stocks due to limited upside at current levels.”

ICICI Securities expects Q2FY10 results to reflect signals of demand recovery in most large-caps' financials. Vertically, it expects BFSI to drive dollar revenue growth for most companies followed by retail. Management comments on demand recovery beyond BFSI would be the key factor to watch for in Q2FY10 results. “Post results, we expect upgrade in consensus EPS estimates for most large-caps (I-Sec FY10E & FY11E EPS estimates for most large-caps are 4-5% higher than consensus).

We remain positive on demand outlook and therefore, expect the valuation downside to be lower. But with the recent run-up in valuations, any correction should be used as buying opportunity. Our top-picks within large caps are HCL Technologies (HCLT) and Tata Consultancy Services (TCS). Rupee appreciation is the key risk to our positive stance on the sector,” the brokerage added.

Specifically, it expects an upgrade in Infosys' FY10 guidance. With earlier guidance significantly on the conservative side and likely strong performance in Q2FY10, ICICI Securities expect Infosys to raise FY10 dollar revenue guidance 2-3% from the earlier 3.1-4.6% decline to flat to 1% revenues decline. It also expects rupee EPS guidance to be raised to Rs100 from the earlier guidance of Rs 94.6-96.

Motilal Oswal believes margins will remain resilient for top tier IT companies with Year-on-year improvement of 50-210 bps. Headcount cuts and hiring postponement could provide upsides to their margin expectations.

“We expect a return to QoQ growth across the top-3 IT companies with growth of 2.2-3.5% QoQ. Volume growth of 1-2% QoQ is expected with 1-1.5% contribution from cross-currency benefits to reported US$ revenues. We expect Infosys to post the highest growth at 3.5% QoQ after a flat 1QFY10. We see the possibility of Infosys' revenue beating our expectations and believe the market will take growth of more than 4% QoQ positively,” the brokerage said.

It added, “We expect Infosys to post revenue growth of 3.5% QoQ in 2QFY10, ahead of its guidance of -1.1% to 0.7% growth. We expect the company to upgrade its FY10 US-dollar revenue decline guidance of 3.1%-4.6% to flat revenue YoY. We expect Infosys to raise its FY10 EPS guidance to Rs102, on expected out-performance of its 2QFY10 EPS guidance. Our expectations build a basic EPS of Rs.26.6 in 2QFY10 versus guidance of Rs.24.1 at the higher end.”

Giving its top picks in the IT sector, Motilal Oswal places its bet on TCS on expected benefits due to trend strengthening in BFSI, greater scope and aggression towards cost management, higher-than-peer-group earnings growth and valuation discount of 17% to Infosys. Among others, the brokerage prefers HCL Technologies and Mphasis.

“We like HCL Tech for its positive correlation to demand stability given high LTM deal signings (75% of its FY09 revenue), strong IMS growth and subsiding of forex loss concerns after FY10 (78% of forex losses expected in FY10). We expect narrowing of valuation discounts as it gets increasingly valued on operations v/s forex concerns. We maintain Buy.

Among mid caps we prefer Mphasis for its highest demand visibility, continuation of ITO growth, significant untapped market within HP, sustainability of margins at 26% and highest delta in case of discretionary demand pick-up (application development is 29% of revenue). We maintain Buy,” the brokerage firm recommends.

Top four IT stocks have outperformed the Sensex in the range of 29 per cent to 118 per cent year-to-date. This was driven by improved economic conditions in key developed markets, stability in demand in the face of expectations of significant declines, companies posting near 12-quarter high EBITDA margins v/s expectations of a decline and cheap valuations and 1QFY10 out-performance.

Analysts believe the valuation gap has largely played out and further up-ticks will be driven by earnings upgrades on volume growth in excess of 3-4% QoQ henceforth, signs of discretionary demand pick-up and new business channel contribution, post budget clarity on FY11 demand and maintenance of margin trajectory.

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