MaSSSoftech

The Q1FY2010 performance of frontline information technology (IT) companies has sprung a positive surprise, beating both our as well as street’s expectation.

Frontline IT companies have shown stability on volume growth and the decline in realisation was lower than expected, which provide comfort against lower-than-expected pricing pressure going forward.

In fact, Tata Consultancy Services (TCS) positively surprised us with 3.5% volume growth during the quarter.

The frontline IT companies exceeded our expectations on margin management. These companies have shown marked improvement of 60-290 basis point sequentially against our expectation of a 40-225 basis point decline.

The positive surprise on the margin front came on account of leverage of offshore model and cost efficiency measures.

Earnings upgrade

Recently, Cognizant, a leading offshore IT service vendor, beat street’s expectation for Q2CY2009 results and has revised upwards its guidance for CY2009.

The management also provided positive commentary on the stability of the banking, financial services and insurance (BFSI) vertical and increased demand for application development.

The strong performance from Cognizant coupled with positive surprises from Indian IT vendors indicates the improvement in the business improvement.

Given the improvement in the business environment, we believe there is scope for further consensus earnings per share (EPS) upgrade.

BPO operations

However, there are still some concerning data points such as muted growth in the business process outsourcing (BPO) vertical reflected in sharp reduction in Genpact’s (a leading pure-play BPO firm) CY2009 guidance.

Recently, Genpact has halved its CY2009 guidance to 6-9% y-o-y growth from 10-15% year-on-year (y-o-y) guided earlier.

The downward revision in the guidance was on account of greater-than-anticipated project cancellation, longer sales cycle and business volume cuts by existing clients.

Furthermore, Genpact’s revenues from GE have come down by 7% during the quarter. In our view, GE is also one of top clients for TCS and GE business cut for Genpact could have a negative implication for TCS.

Outlook

We have marginally revised upwards our earnings estimates for Infosys on the back of improvement in the business environment.

For HCL Technologies (HCL Tech), we have only considered the lower effective tax rate in FY2011 on extension of software technologies park of India (STPI) benefits and will further revisit our earnings estimates post its Q4FY2009 results (June year ending).

Given the improvement in the business environment, we see further scope to upgrade the consensus earnings of the front-line IT companies. However, we believe the street has already factored in most of the earnings up-gradation, leaving limited upside at current levels.

Hence, we maintain our HOLD recommendation on frontline IT companies. Though, we see limited upside in frontline stocks, we prefer TCS among them given its stellar performance in Q1FY2010 (leading to sharp earnings up-gradation) and stability in the BFSI vertical.