IT sector results preview for Q3FY12: Angel

Angel Broking has come with its December quarterly earning estimates for software sector. According to the research firm on the back of absorption of wage hikes, which were undertaken in 1HFY2012, and sharp INR depreciation, profitability of tier-I companies such as TCS, Infosys and Wipro is expected to rebound by 20.4%, 15.3% and 14.3% qoq, respectively, in 3QFY2012.

Angel Broking earning estimates:

Macro data points hint slowdown in developed economies

In June 2011, the IMF forecasted that global GDP is set to grow by 4.3% and 4.5%, respectively, for CY2011 and CY2012. However, rising sovereign debt due to quantitative easing (QE) measures and bailouts led to gross debt to GDP of developed economies such as US, UK and Eurozone surge to an alarmingly uncomfortable zone. Further, as the effect of QE measures is gradually fading, economic data points for developed economies are also moving back into the alarming zone. As a result, the IMF has marginally downgraded its global GDP growth forecast to 4.2% and 4.3% for CY2011 and CY2012, respectively. This forecast is again expected to be downgraded further, given the contraction in manufacturing activities across the globe. The downgrade has, however, been steep for the US, from 2.5% and 2.7% for CY2011 and CY2012 to 1.6% and 2.0%, respectively. In case of Eurozone, the forecast has been trimmed marginally from 2.0% and 1.7% to 1.9% and 1.4% for CY2011 and CY2012, respectively. For November 2011, data points for the US economy have emerged largely negative. For instance, 1) manufacturing index stood flat mom at 52.0; 2) nonmanufacturing index fell to 52.0 from 52.9 in October 2011; 3) industrial production came in at -0.2% as against 0.7% in October 2011; 4) consumer confidence index stood flat mom at 56; 5) retail sales growth rate stood merely at 0.2% (flat mom); and 6) 3QCY2011 GDP growth came in lower than expected at 1.8% yoy (estimated: 2%). However, there were some positive indications from data related to unemployment rate, which decreased to 8.6% from 9.0% in October 2011, leading to an increase in consumer confidence index to 56. Globally, large selective banks have announced planned layoffs to curb costs, such as UBS (3,500 employees, 5% of its global staff), Credit Suisse (2,000, employees, 4% of its global staff), HSBC (30,000 employees, 10% of its global staff by CY2013) and Bank of America (30,000 employees, 10% of its global staff by CY2014).

Slowdown in the west may cause CY2012 IT budgets to go soft

In CY2008, Lehman Bankruptcy was the starting point when clients revisited their spending on IT and reduced most of their discretionary spending. Layoffs in the form of pink slips were sudden to pull the lever of variable costs, as revenue dipped. In CY2011, the S&P downgraded US credit rating from AAA to AA for the first time ever in the history of US. This led to panic selling in IT stocks during August 2011, as developed economies are the key markets for IT companies. However, henceforth since the past four months, the INR depreciated sharply against USD, giving a boost to INR revenue, operating margins and overall profitability of all IT companies. Hence, the IT index rose by 9.0% in 3QFY2012 in anticipation of higher growth. The recent financial results of Oracle, the global enterprise giant for the quarter ending November 2011, raised questions about the health of the technology sector, as the company's new software sales grew by merely 2% yoy because of delays in decision making by clients, which led to deals not being closed. We expect moderation in IT budgets for CY2012 and expect volume growth for Indian IT companies to scale down to sub- 15% from 20% plus. However, we have not built in any pricing erosion because, post CY2008, the current pricing is still at a discount to the peak levels.   

Utilization to be a mixed bag

In 3QFY2012, we expect the utilization level (including trainees) of Infosys and TCS to increase by merely 10bp qoq each to 70.3% and 76.5%, respectively, as 3Q typically has lower number of working days as compared to all other quarters due to the holiday season onsite. In case of Wipro, we expect utilization level (including trainees) to increase by 90bp qoq to 77.0%, as freshers hired in the last two quarters are expected to start getting billed. However, for HCL Tech, we expect utilization level (including trainees) to drop by 90bp qoq to 75.7% on the back of absorption of a higher number of freshers. In case of tier-II Indian IT companies, utilization levels of most companies are expected to move down primarily because these companies are chasing to achieve the flattening of their employee pyramids by hiring freshers. Most of the campus hires joined the companies in 2QFY2012 and will be on the training period in 3QFY2012. Hence, we expect utilization levels of Hexaware, KPIT Cummins, Mahindra Satyam and Persistent to slip by 10bp, 30bp, 20bp and 40bp qoq, respectively. However, in case of Tech Mahindra, we expect utilization level to rebound by 40bp qoq because of fresher hiring done in 1QFY2012, which will turn billable in 3QFY2012.

Cyclically a weak quarter but with modest 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. For 3QFY2012, we expect volume growth to remain at 2.7-4.9% qoq for tier-I IT companies, with Infosys leading the pack and Wipro at the fag end of the range. For tier-II companies, we expect growth to be modest at 2.0-4.0% qoq, as utilization is expected to remain almost flat qoq, as higher number of freshers came on board in 2QFY2012 and most of them will be in the training period during 3QFY2012. Hexaware and Mahindra Satyam are expected to be the leading tier-II companies, whereas Mphasis is expected to be at the bottom.  USD revenue to grow, albeit at a slower pace The cross-currency movement, which had proved to be a boon since 2QFY2011-1QFY2012, has turned into a bane since the last quarter. In 3QFY2012 again, it has turned into a spoilsport with the USD appreciating by 4.6%, 2.4% and 3.7% qoq against the Euro, GBP and AUD, respectively. This will negatively affect USD revenue of Infosys, TCS, Wipro and HCL Tech by 0.9%, 0.9%, 1.0% and 1.2% qoq, respectively. Amongst the entire IT pack, Tech Mahindra is expected to be the highest loser due to unfavorable cross-currency movement by 1.8-2.0% qoq.  For 3QFY2012, on the back of modest volume growth, stable pricing and unfavorable cross-currency movement, we expect USD revenue to grow moderately by 1.7-4.0% qoq. For tier-II IT companies, USD revenue growth is expected to be 0-4.1% qoq, with Hexaware and Persistent leading the pack. INR revenue to shoot up, courtesy sharp INR depreciation 3QFY2012 witnessed one of the most volatile seasons as far as the currency is concerned. During 3QFY2012, INR depreciated by ~11% qoq against USD, which will result in surge in INR revenue growth vs. USD revenue growth and boost the operating margins of IT players by 350-400bp qoq. In INR terms, revenue growth is expected to be whopping at 11.3-14.0% qoq for tier-I IT companies due to depreciation of INR against USD on a qoq basis, with average USD/INR rate at 50.8 for 3QFY2012 as against 45.8 in 2QFY2012. 

For tier-II IT companies, INR revenue growth is expected to be 6.5-15.6% qoq, with MindTree and Hexaware leading the pack.

Margins to improve

We expect EBITDA margin of the entire tier-I IT pack to improve because of sharp INR depreciation against USD. Infosys is expected to record margin expansion of 159bp qoq to 32.6% despite the flowing in of the negative impact of promotions given during the quarter. TCS and Wipro are expected to record margin improvement of 164bp and 137bp qoq to 30.7% and 24.5%, respectively. For HCL Tech, we expect EBITDA margin to improve by 255bp qoq to 19.6% as the negative impact of wage hikes given in the last quarter will get absorbed in 3QFY2012 along with INR depreciation.

For tier-II IT companies (excluding Mahindra Satyam), we expect efficiency gains, INR depreciation and moderate volume growth to push EBITDA margins higher on a qoq basis. EBITDA margin of Tech Mahindra, MindTree, Persistent, Hexaware and KPIT Cummins is expected to grow by 209bp, 299bp, 287bp, 140bp and 313bp qoq to 17.4%, 15.9%, 21.9%, 20.1% and 16.8%, respectively. In case of Mahindra Satyam, wage hikes were given in 3QFY2012, so the company is expected to record a 45bp qoq decline in its EBITDA margin to 14.9% (low impact as INR depreciation absorbed most of the effect).

Earnings growth to be a mixed bag

On the back of absorption of wage hikes, which were undertaken in 1HFY2012, and sharp INR depreciation, profitability of tier-I companies such as TCS, Infosys and Wipro is expected to rebound by 20.4%, 15.3% and 14.3% qoq, respectively, in 3QFY2012. For HCL Tech, profitability is expected to surge by 26.6% as the effect of wage hikes will be absorbed and BPO losses will likely reduce in 4QCY2011. Amongst mid-tier IT companies, profitability of Hexaware, KPIT Cummins, Infotech Enterprises and Mphasis is expected to grow by 5.1%, 2.2%, 15.3% and 17.1% qoq, respectively, majorly because of strong improvement in their margins (due to INR depreciation) and hedges turning into in-the-money (ITM). For Mahindra Satyam, profitability is expected to fell by 20.3% qoq to `190cr due to wage hikes given during 3QFY2011. In case of MindTree and Persistent, profitability is expected to fall by 24.4% and 22.7% qoq, respectively, due to lower other income during 3QFY2012.

Outlook and valuation

The global macro data is pointing towards a bleak outlook for future global corporate profits, though currently S&P 500 quarterly profits have ticked in a lifetime high. Further, there is now cautiousness coming from few IT players in terms of IT budgets for CY2012. However, as per TPI's recent report, deal pipelines of IT companies are expected to be higher in 2HCY2011, as indicated by the managements of selective companies such as HCL Tech and Infosys. This indicates disconnect between the macro picture and client behavior. Thus, we expect tier-I IT companies (except Wipro) to replicate growth of 20% plus in FY2012. Further, we expect moderation in volumes to sub-15% only in FY2013. However, in INR terms, we expect growth to be higher as we have revised our USD/INR assumption for FY2013 to be at 49, following a steep 12% depreciation against USD over the three months. We remain cautiously optimistic on the IT sector due to looming macro concerns as on one hand lot of global as well as domestic uncertainties are prevailing while on the other hand software companies are deriving benifits from steep INR depreciation against USD. We prefer diversified players such as Infosys, TCS and HCL Tech (top pick) in tier-I IT companies. In case of tier-II IT companies, we like Mahindra Satyam and Hexaware.

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