Key takes from interaction with Infosys management: Infosys has indicated that Q3 revenue growth would be closer to the lower end of 3.2-5.4% quarter-on-quarter guidance. Consequently, revenue growth for the full year would also be at the lower end of their full-year growth guidance of 17-19%, according to management. We believe this is largely in line with our expectations of 18% growth in FY12F (although slightly lower than street expectations, which are nearer to the top end of the guidance). The 13% growth expectation for FY13F (forecast) already builds in slowdown impacts, in our view.
Infosys? Q3 guidance assumed sustainability of the sharp pickup in client activity witnessed in Aug-Sep, which management now indicates has not materialised as, decision making delays have elongated, no cancellation yet, large programmes are going through a second level of scrutiny and pace of project ramp-ups slower than contractually agreed as clients reduce cash burn rate possibly on, year-end cash conservation strategy and uncertainty on the macro front.
Infosys says the reason for the higher than usual 2% differential between top and lower end guidance for Q3FY12 was on account of the uncertainty in client spending. Management believes Infosys could see a slightly higher revenue impact compared to peers as discretionary portions are 35% of revenue, but maintains the higher exposure is a conscious strategy to break away from the commodity service play.
Client decision making has not stalled: Clients are looking at ways to reinvest in business, but looking at doing this through reallocation of cost savings. This is the same reason why clients would work collaboratively with vendors to cut costs rather than impose immediate pricing cuts as seen during the last downturn.
Budgets have not been completely closed, but client indications are for flat to marginally negative budgets. Infosys expects BFSI (banking, financial services and insurance) budgets to be flat to marginally down?although some large banks could hike discretionary spending. Regulation spend by banks could be 4-5x (times) of M&A integration spend, but is likely to be more spread out compared to latter. In retail/CPG (consumer packaged goods) budgets have not been decided yet; in manufacturing management is positive on hi-tech/auto but see cuts happening in discrete manufacturing. Telecom is likely to remain sluggish; while management has a positive outlook on energy & utilities.
Management has indicated the whole of rupee depreciation benefits might not show in margins as some savings would be reinvested in solutions and platforms. Pricing is likely to be stable and structuring of contracts through higher fixed bid/offshoring/ outcome based pricing would take care of client needs to cut costs. Wage hikes are likely to moderate next year ? could be in the 5-6% to 10-12% range across levels. Variable compensation is 30% of Infosys? offshore salary cost (18-20% of revenue); however, management would use this margin lever only as a last resort.
Key takes from TCS management and differences with Infosys seasonal weakness in Q3: TCS management expects Q3 revenue growth to be impacted by seasonal weakness in the December quarter due to holidays/ shutdowns but not on account of any demand weakness (which is contrary to Infosys commentary). Some impact of the seasonal weakness would be felt in Mar-12 quarter as new project starts typically happen around February, and discretionary decision making typically starts only by March.
TCS indicates no red flags, with decision making happening across discretionary/non-discretionary service lines and across geographies/ verticals. Management remains confident on growth and expects a bigger chunk of growth to come from shift from inhouse to offshore outsourcing, with rebid action largely restricted to the IMS (infrastructure management services) space. Regulation related spending could start from FY13F onwards post framing of the Dodd Frank rules by Dec-2011 or Jan-2012.
TCS indicates flattish budgets in BFSI for FY13 (compared to Infosys management?s indication of flat to low single digit cuts in budgets). TCS expects the benefit of rupee depreciation to largely flow through to margins, and has not indicated any moderation in wages for FY13F (compared to some moderation indicated by Infosys).
TCS expects pricing to be stable, however believe given the mix of businesses realisations are much more difficult to predict.
TCS has $1.3bn of hedges at USD-INR of 47.50 maturing in Q3FY12F and a similar number in Q4FY13F, with just about $200-300mn of hedges for FY13F. TCS had R5.3bn of accumulated forex losses in the balance sheet as of Q2FY12 (when USD-INR rates closed at 49 levels, current rates are in excess of 53).
We reiterate Buy on Infosys and prefer Infosys over TCS despite Infosys?more cautious commentary as we expect, limited differentials in revenue growth over the next two quarters (similar to the previous quarter), Infosys to benefit most from rupee depreciation, with lower forex loss impacts compared to TCS, Wipro or HCL Tech.
Valuations are already discounting the cautious outlook with TCS trading at a 15% premium over Infosys on our estimates. To sum up, we believe that while TCS will likely exhibit greater predictability, higher returns are likely to be generated at Infosys as it is better poised for a rebound situation in H2FY13F. We would view any near-term disappointments due to Infosys? higher discretionary exposure as good entry points to the stock.