IT services: All's not well

Analysts believe FY12 earnings estimates are aggressive, stocks may correct further.

When it comes to rating Information technology (IT) stocks, select brokerages appear to have undergone a willing suspension of disbelief. Despite constant warnings by Infosys on an ever-weakening macro outlook in the US, they have chosen to dismiss it as a part of the company’s usual conservative approach. Even the fact that rivals TCS and HCL Tech were posting better numbers did not help. Failing to see the writing on the wall, some investors continued treating IT as a safe haven, given that several inward-looking sectors were reeling under high interest rates and margin pressures.

On August 3, a foreign brokerage released a report titled “Two Sides of a Good Coin,” while another raised the sector’s revenue growth guidance for calendar year 2011 from 29 per cent to 32 per cent. Some brokerages remain conspicuously silent, even after the US downgrade on August 5. However, the market has hit the sell button. Infosys shares are down nearly 22 per cent since the beginning of this month. Even as most analysts believe that Infosys and some of the bigger players will meet their guidance for the current financial year, it’s becoming apparent that it won’t be business as usual in FY13.

Given that a lot of deals will come up for renewal between October and December this year, Standard Chartered Securities expects CY12 IT budgets to be flat and applications outsourcing deals may see tougher negotiations. “Maintenance contracts could see y-o-y rate card cuts (though not as sharp as 10-15 per cent cuts of 2008-09).”

As the spectre of a slowdown hangs over their heads, companies may stray from pricing discipline to sustain growth in revenues, believe analysts.

According to ICICI Securities, "Estimates for IT companies are already very aggressive for FY12, with the risk being more towards the downside than further upside. Likewise, valuations aren't terribly different from the historical averages, and, generally speaking, remain high."

Deterioration in the macro outlook could drive a further 20-30 per cent slide in prices. Currently, HCL Tech is the only stock that appears to be closest to its trough levels, as sharp EPS cuts are being built in. On the other hand, "flight-to-quality" appears to be restricting the downside for Infosys.

Emkay Global believes negative news flow may impair CY12 budgeting cycle and, thereby, pose downside risks to FY13 earnings estimates. The brokerage has cut target prices of Tier-I IT companies by 23-29 per cent. Also, driven by a 9-11 per cent cut in FY13 earnings estimates, it has lowered FY13 dollar revenue growth estimates to 11-16 per cent (compared to 18-20 per cent earlier).