Pankaj Kapoor, analyst, Standard Chartered, shared his outlook on the IT sector just ahead of the earnings season, with Sunaina Vasudev.
 
What are your expectations from the results of frontline information technology (IT) companies for the March 2011 quarter?
 
We feel that this will be a weak quarter compared to the previous one primarily due to seasonal factors and also due to budgets set last year.
 
We are looking for 3-3.5% volume growth in 4QFY11. Given that cross currency has been relatively favorable this quarter, realisation growth is pegged between 0.7 to 0.9%. On a constant currency basis, the realisation gains in March 2011 quarter would be because of the change in portfolio mix.
 
However, this impact wouldn’t be very significant immediately. Hence, I am conservatively building in a flattish to a marginal increase and we expect net volume growth to come in between 3.5-4% for 4QFY11.
 
Margins should remain stable because of flattish utilisation as the volume scenario wasn’t very strong, while companies hired extensively in the last couple of quarters. Infosys had even guided for a margin drop this quarter and TCS had also hinted to a possible margin fall. The only company which will stand out from a margins perspective will be HCL Technologies.
 
How do you expect FY12 guidance to pan out?
 
Nasscom guidance is around 18% for next year and Infosys typically guides ahead of industry growth. I feel the company could be riding for 18-20% dollar revenue growth. Over last three years, Infosys’ guidance factored a flat pricing rate (at previous quarter levels).
 
If Infosys, for instance, should come out with a guidance of around 20% revenue growth, the possibility for them to achieve current consensus estimate of around 23% is highly likely and market will take this as neutral to positive. But if the guidance is less than 20% it will be negative. But at 20% there is also headroom for earnings to go up depending on the way the currency behaves.
 
Based on our channel checks and meetings with management all of them are sounding positive on pricing, deal wins and deal pipeline, which continue at historical levels. Infosys has won about 3-4 large deals in the quarter and the pipeline continues to be strong at the normal 10-15% range.
 
What do you see as the key risks to guidance (positive or negative impact) and the actual likelihood of their actually coming to pass?
 
Generally, I expect wage hikes should be lower than last year, around the 10-12% band. Also, this is the year when there will be higher share of fresher hiring that should bring the lower the effective wage growth.
 
A higher number is a negative risk but it doesn’t look very likely as companies are close to finalizing wage hikes for the year and it looks like it will be within this band rather than higher.
 
I don’t think that currency will move significantly either way according to most forecasts. Also, there are general risks from any significant macro-economic event that can impact IT budgets and services.
 
How do you view current valuations for frontline IT stocks in this backdrop?
 
Valuations-wise, I think, that they are fairly priced at around 20-22x. The top three are in a band of 22-23x, so I don’t see much of a valuation story coming out. Probably, you will see some earning upgrades as valuations shift towards FY13 which will reflect in stock movements.
 
The stocks should track the earnings on the comfort that things are fine and you may see the premium to the market again going up. Typically, earnings upgrades will be a continuous process every quarter as pricing will not change in one quarter but will play out through the year.
 
What are your key mid-cap picks in the sector and why?
 
As a basket, I think, mid-caps will continue to have issues although because of the rupee stability they should come out with good results. Given that valuations are at a significant discount to the large caps, you will see some buying interest coming into the mid-cap stocks.
 
However, as larger institutional investors are not very positive about the basket as a whole, that will cap the valuations upside. Also, the high risk of quarterly volatility will also keep the valuations under check.