Good times ahead for India's top two IT majors

The recovery in demand in key markets around the world is being reflected in the recently announced March quarter results of TCS and Infosys. Consulting firm Gartner expects information technology (IT) spending to grow 5.3 per cent for 2010 in line with the overall improvement. The only spoilsport in the story is a currency headwind as the rupee continues to head north.

Growth picking up
Both the IT companies delivered an increase of 4-5 per cent in volumes, which indicates an upsurge in deal closures. On the back of higher volumes, the North American market and banking, financial services and insurance (BFSI) continue to do well. As the TCS management claimed, growth is becoming broad-based with most of its verticals delivering either flat or positive growth in this quarter. However, Infosys hasn’t seen that traction in all its segments.

BFSI and manufacturing segments have been the outperformers growing at 7-9 per cent sequentially. This helped Infosys churn out a 3.5 per cent sequential growth in rupee terms on the revenues front, while TCS was able to manage 1.2 per cent for the quarter.

Margins may fall
Operating profit margins took a hit of 70-150 basis points (bps) due to unfavourable currency movements for the two IT majors. With wage hikes taking effect, the pressure on the margins was evident. Overall, Infosys had seen its margins drop lower by 150 bps to 34 per cent. V Balakrishnan, CFO, Infosys, says: “If we are to peg the exchange rate at Rs 44.5 to the dollar, there would be a 6 per cent rupee appreciation that could impact margins by 2.5 per cent for 2010-11. Inclusive of the wage hikes, the net impact on the margins for the full year is only 150 bps.”

Unlike Infosys, a tab on the operational expenses helped TCS report margins of 30.2 per cent — an increase of 50 bps sequentially. In fact, TCS was able to report an improvement in margins in the last four quarters, narrowing the margin gap. The gap of 800 bps in favour of Infosys a year ago has now been halved and stands at 400 bps.

Although currency and wage hikes could put pressure on margins, companies might look at levers like better utilisation (especially in the case of Infosys) and optimal offshore-onshore mix to counter margin pressures.

IMPROVING METRICS
	Infy			TCS
	Q4 FY09	Q3 FY10	Q4FY10	Q4 FY09	Q3 FY10	Q4FY10
Revenues	5,635.0	5,741.4	5,944.0	7,172.0	7,649.0	7,738
% chg (q-o-q)	-2.6	2.8	3.5	-1.4	2.9	1.2
OPM (%)	33.6	35.5	34.0	25.8	29.7	30.2
Net profit	1,613.0	1,582.0	1,617.0	1,333.0	1,824.0	2001.0
% chg (q-o-q)	-1.7	2.7	2.2	-2.1	11.1	9.7
Fixed price projects	38.3	38.3	39.5	47.1	48.0	48.7
Capacity Utilisation	74.5	76.2	77.1	79.7	81.1	81.8
North America	64.6	66.6	66.1	57.2	57.4	58.8
Source: Company

Conclusion
IT stocks outperformed the domestic indices in the last two quarters on the back of improving business environment and encouraging forecasts. The good run is likely to continue as revenue guidance by Infosys seems to be ahead of Street estimates for yet another time. IT majors are also looking to add workforce to manage higher business volumes.

Further, Andrew Bartels, VP, Forrester Research, confirms the US and Asia-Pacific will be standout regions, while Western and Central Europe would expand at the slowest rate. Although there has been a broad-based growth among the segments, telecom and application development and maintenance are still not out of the woods.

Infosys and TCS are trading at 23 times and 21 times their 2010-11 earnings respectively. The trading premium that Infosys enjoyed over TCS is likely to reduce, going ahead. Both stocks could be added to your portfolio from a two-year perspective.