The December quarter results and forecasts by industry experts indicate that domestic IT companies should see better days ahead

The superlative December quarter results from the Big Three IT companies renewed hopes that the worst is over for the IT sector. Higher volumes helped the tech majors to deliver the goods in a traditionally weak quarter. While the improvement in the global economic situation is a positive, the lack of pricing improvement suggests that clients of Indian tech majors are still not out of the woods. Many had expected the top domestic IT companies to report flattish revenue growth for the quarter. However, better volumes ensured that revenues of the top three companies, which account for over 85 per cent of the weight in the BSE IT index, grew at an average of around 2 per cent in rupee terms and 6 per cent in dollar terms, on a sequential basis. The North American market and banking and financial services and insurance (BFSI) space which stabilised in June 2009 quarter, saw improvement in September quarter which strengthened in December quarter on the back of higher volumes. On top of it, better than expected margins indicate that the companies were able to rein in costs without hampering growth. However, despite good results, IT stocks were not exactly chart toppers on the indices. The reasons? Negative sentiments surrounding the proposed restriction on US banks and IT stocks that were major outperformers in the last three months are cooling off; the Big Three delivered an average return of 23-25 per cent compared to flat Sensex returns. A strengthening rupee could be a medium-term dampener.

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Deal flow rising?
While business confidence is getting restored, earlier investments on the sales and marketing front (strengthening client partnerships) are also paying dividends for IT companies. However, most top IT vendors sound cautiously optimistic regarding growth prospects. Kris Gopalakrishnan, CEO & MD, Infosys Technologies, “Indications are that the budgets are going to be flat but offshore-outsourcing would go up. About 60 per cent of the clients are yet to finalise. The allocations have to be made. It is also possible that because the budgets are not closed there may be delays.”

Notably, the recent quarter saw a visible improvement in new client additions by the IT companies with the signing of deals in the $100-200 million range. N Chandrasekharan, CEO and MD of Tata Consultancy Services (TCS), further adds, “We are pursuing 20 large deals and the pipeline looks healthy, however, it will take at least a few more quarters for pricing power to return.”

Broader recovery
Among key verticals, the BFSI space which accounts for more than a third of revenues of top IT companies, helped deliver a robust quarter. Infosys’ BFSI revenues grew by 6 per cent sequentially (it added 14 BFSI clients during the December quarter), while the same for TCS and Wipro was 3 per cent and 1.6 per cent, respectively. Positively, the companies also indicated that demand from customers from other segments such as retail, energy, utilities and pharmaceuticals is also improving. Nevertheless, the companies are still cautious about the recovery in the manufacturing and telecom segments. Should there be a pick-up in these segments, expect growth rates to be better than the 2010 forecast.

Within geographies, the US which accounts for nearly three-fifths of the total IT revenues held up well. However, contributions from other geographies like India and rest of the world, which though contribute between 12-16 per cent to total revenues of the top companies, did better with revenues growing between 9-20 per cent sequentially. Nevertheless, a recovery in Europe, which is expected to lag the US recovery by 1-2 quarters, would be crucial for the momentum to sustain.

Margin trend
Operating profit margins (OPM) in the third quarter improved. While Wipro’s OPM improved by 40 basis points, the other two majors saw margins improve by 90 to 120 basis points. Lower administration and selling expenses helped to some extent. The higher employee utilisation of around 80 per cent was the larger contributor to margin improvement. With business prospects expected to improve, IT companies have gone into the hiring mode again. The Big Three added a net of around 17,000 employees during the quarter, besides scaling up yearly hiring targets and bench strength to meet the higher forecasted demand. The gross hiring for IT majors is estimated to be 20,000-22,000 for the fourth quarter as against about 24,000 in the December 2009 quarter.
 

Besides increased hiring, wage hikes and greater marketing spends could mar operating margins, going ahead, believes Sandeep Muthangi, analyst, IIFL. Rupee appreciation, too, is an issue.

Nitin Padmanabhan, analyst, Centrum Broking says, “Rupee appreciation is a head wind for 2010-11. However, we believe the full year average would remain at Rs 45 to a dollar. Manpower additions are likely to keep up with demand. For the next quarter, however, margins could observe a decline of 50-60 basis points for the IT majors”.

Mid-cap IT
Looking at the broader landscape, stability might have returned to the IT biggies. However, mid-caps are showing mixed fortunes with the likes of Subex and Rolta surprising the Street with a good set of numbers, while Mastek delivered poor numbers. On the broader level, a little more than half the 13 companies (with market capitalisation between Rs 500-3,000 crore and which had declared results till January 22) showed a higher sequential revenue growth. In June 2009 quarter, 9 of these 13 companies had reported a decline in revenues as compared to the March 2009 quarter. Notably, a larger number has shown an improvement in operating profit margins in the December quarter. Going ahead, if the trend in IT spends sustains, it could help the IT mid-cap companies. Stock valuations, however, are already high thereby capping further upsides.

Overall, although IT stocks have already run up in anticipation of the improving outlook, not all is lost. Read to know how the top companies fared in the recent quarter and their outlook going ahead.

Infosys
Infosys Technologies’ December 2009 quarter kicked off the results season and raised hopes of better prospects. Its strategy to cross-sell services to existing clients and a pick-up in demand ensured volumes were up 6.1 per cent in the quarter. Overall, good demand from North American customers and the BFSI segment coupled with a steady pricing environment helped Infosys report a 6.8 per cent sequential growth in dollar revenues, which is the highest in the last seven quarters. However, the 3.6 per cent appreciation in the rupee shaved off growth in rupee-based revenues for the company.(See table)

At the operating level, profit margins improved by around 90 basis points to 35.5 per cent on account of pricing stability and better employee utilisations. Going ahead, unfavourable currency movements, salary hikes and an increase of hiring targets put together could put some pressure on the margins. On these counts, the management expects margins to decline by about 150 basis points in the current quarter. However, with pricing environment stable and customers taking decisions faster, the ongoing global economic recovery suggests that the demand environment should improve further. Even as IT budgets are yet to be finalised, the up-tick in Infosys’ full-year guidance instils confidence of better days ahead. The stock is trading at 22 times its 2010-11 earnings estimates, and may be considered on dips.

TCS
TCS’ stock has been an outperformer since July 2009. It brought cheers to its investors yet again with another set of good quarterly numbers. For December 2009 quarter, volume growth at 6.6 per cent was better than expected and the highest in the last eight quarters. TCS was able to extract higher volumes from its top client wherein revenues were up 26.6 per cent sequentially. A broad-based improvement in demand suggests that the economic recovery is gaining momentum in its key markets such as the US and the Europe. Notably, Asia-Pacific and India saw strong up-tick in demand with revenues up 23.8 per cent and 13.7 per cent, respectively. While the share of the BFSI segment was stable, others like telecom and technology, which were under pressure in the last 4-5 quarters, saw a revival in the demand helping them report a higher share of revenues.

Better utilisations and an increase in offshore leverage helped TCS improve its operating profit margins by roughly 100 basis points to 29.7 per cent; it’s highest in more than four years. Positively, the management expects to maintain margins at current levels, going ahead. India’s largest software exporter added 7,700 employees (net), after reporting a decline in net additions in the last three quarters. TCS also closed 10 large deals and is pursuing at least 20 more in the current quarter. The increase in hiring activity and trend in large deals are among indicators of improving demand going ahead. Although TCS’ stock may not continue to outperform the broader markets as it did in the recent past, at 20.4 times its 2010-11estimated earnings, it can be considered for investment.

Wipro
After a superlative performance in the second quarter, Wipro managed yet another quarter of good growth (above street expectations), though it did not beat its counterparts. Business volumes grew at 4.7 per cent in the December quarter (lower than TCS’s 6.6 per cent and Infosys’s 6.1 per cent), while average pricing slipped by 1.5 per cent. Lower exposure to BFSI segment amongst the top three players, which saw a major recovery recently, is the reason for relatively lower volumes. Amongst verticals, BFSI grew at 3.8 per cent sequentially, while healthcare and energy delivered a growth of 11 per cent and 9 per cent, respectively. In terms of geographies, Europe witnessed a strong growth of 5.7 per cent sequentially, as the company won three deals in the third quarter, while Indian and Middle Eastern markets grew by 15 per cent. A favourable fixed-price mix and higher employee utilisations helped margins improve 40 basis points to 19.5 per cent.

The management is confident that the BFSI segment could see higher traction going ahead and a broad-based sequential growth is expected across most of its verticals, service lines and geographies, sizing up a positive demand environment. The stock is trading at 20.6 times its 2010-11 earnings and can be considered at dips.

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