IT Services - Q3FY14 Result Preview - Tough QoQ comparison, but benign environment helps - Kotak

IT Services companies under our coverage are expected to report relatively muted earnings in 3QFY14. QoQ comparisons will be tough due to lower rupee realizations, furloughs with many customers and holidays typical of the season. But with a slightly positive demand environment, we maintain BUY across most of our coverage universe with top picks being HCLT, TCS and eClerx. We maintain SELL on Infosys as we see challenges with sales attrition and client losses as it struggles to reposition itself and we move Infotech Enterprises to HOLD due to the limited upside even with our upgraded estimates.

Seasonal drag on QoQ revenue growth, but not as bad as last year: In 3QFY13, Hurricane Sandy caused shutdowns in the east coast. Though we had to lower our expectations for the quarter due to continued furloughs this year, YoY comparisons will still be favourable. Only negative surprises we anticipate are TechM lagging on account of furloughs in Telecom and Manufacturing (which are their key verticals) and Infosys on account of offshore revenue shift and billing pressure.

Margins to be hit, but expect higher earnings as forex losses narrow: Reported utilizations will be depressed for most firms (except TCS which reports utilization excluding holidays and paid-time-off). While QoQ USD-INR realizations may be flat or even down depending on the days billing was realized over this volatile quarter, we expect forex losses to narrow across all firms under our coverage. In addition to the impact of lower INR realizations, HCLT's margins will also be impacted this quarter due to the effects of salary hikes for part of its workforce.

New discretionary spending onsite heavy; large deals crucial for growth: We expect the demand environment to improve slightly for traditional areas of discretionary spending (packaged software implementation) while expecting more spending on new technology areas such as analytics and visualization. We note that these new areas of spending are expected to be onsite centric (per Accenture's mgmt. commentary) and thereby question Infosys' strategy of shifting more work offshore at this juncture. We continue to maintain that market-share gains (against MNCs and each other) will drive growth for India Tier-1 and consider Infosys at serious risk of revenue losses as it struggles to change its earlier premium positioning. Attrition among sales personnel will put additional stress.

Recommendation and key risks: We maintain BUY on HCLT, TCS, Wipro, TechM and eClerx. We also maintain SELL recommendation on Infosys. We have changed our recommendation for Infotech Enterprises to HOLD with a Dec'14 Target Price of Rs 390 (Vs 283 earlier). We have changed our target multiple for eClerx to 11x (from 10x earlier) considering its industry leading return metrics and the more stable demand environment. Key risks to our thesis are (1) currency volatility and (2) Regulatory changes such as the US Immigration Bill (more likely to come up again as the next legislative focus, now that a temporary budget deal has been reached).

Source : Equity Bulls

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