Merrill Lynch - Computer Services

Merrill Lynch in their report on Computer Services

Growth led 20%+ stock upside despite INR led EPS & PO cut
Retain our positive stance on sector, given forecast 2-yr EPS growth of 18 to 27%, even post earnings cut of upto 6% over FY08 & FY09, for the top four IT vendors. Our estimate cuts factor in avg Rs41/USD & Rs40 for FY08E & FY09E (vs earlier Rs42.5 & 41.5) offset by upside to rev growth and companies pushing on margin levers. High treasury yields also helping. Post PO cuts of upto 8% we still expect over 20% potential upside. We see triggers in strong H2 & possible Re depreciation.

Revenue could surprise; Margin cushions being used
Channel checks and our ML CIO survey in late April, boost our confidence in robust demand of 30 to 35% revenue growth in USD terms. We believe the stronger Rupee is adding weight to negotiations for bill rate hikes. Vendors are also focusing on utilization, with recruitments passing through heightened scrutiny. Travel & G&A costs are being tightened, apart from continued efforts at offshoring and broadening of employee pyramid.

Brace for a bleak Q1; Infy annual Re EPS guidance cut likely
Measures to protect earnings, as above, would take a few quarters to bear fruit and we believe investors need to brace for the Q1 shock of companies missing guidance by 4 to 6% and for sequential declines in profits of 3 to 9% in recurring earnings for the majors. For the first time, we believe, Infy may have to lower annual EPS guidance by 3 to 5% implying 17-20% Rupee EPS growth.

INR surge largely priced in; Top picks TCS & Infosys; Niche plays Rolta and Educomp
Believe the 3-month 15% sector underperformance has largely priced in INR concerns. We expect Q1 weakeness will be priced in when we are close to July results season. Our top picks of the secular trend are leaders TCS and Infosys, where TCS has greater margin levers and is seeing broad based client traction. Top niche growth ideas are Rolta and Educomp, in our view, which stand out in our coverage as India stories insulated from forex fluctuation.