Don't bet on IT this quarter

Higher wage bills (on account salary hikes and new employee additions) and lower employee utilisation rate are expected to pull down the average net profit growth of frontline IT companies in the second quarter (July-September).

According to estimates by key brokerage houses, average quarterly net profit of the top five IT companies is expected to be 1.7% lower compared with the previous quarter (April-June). This, despite the fact that quarterly revenues have risen at an average 3% during the period under consideration.

While the growing strength of the rupee has been scaring away prospective investors in IT companies, analysts point out that the rupee has little to do with the sluggish performance of these companies during the latest quarter. While the rupee breached the psychological 40-mark to the dollar last month, it did not rise much in second quarter compared with the previous quarter. Consequently, companies that had entered into forward transactions as a hedge against the rising rupee did not gain much from these transactions. That has also contributed to the slackness in their bottomlines.

Moving forward, the strength of the rupee and the slowing down of the US economy will remain the two major challenges for the sector. “Indian IT companies have a huge exposure to the banking, financial services, insurance (BFSI) vertical. The subprime crisis may affect the discretionary spending which accounts for 20% of the total IT spend by clients,” says Sushil Finance analyst Parikshit Kandpal.

However, he sees this as a temporary shock as a slowdown in the US could prompt more companies there to increase outsourcing to India in a bid to cut costs. IT shares have underperformed during the recent rally as investors expect margins to be under pressure because of strengthening rupee. These shares have been on a downtrend since March this year as the dollar began to weaken against the rupee.

The rupee gained 7.5% to the dollar during April-June and another 1.9% in the following quarter. “Expect September 2007 to be a quarter with strong sequential revenue growth, but unexciting profit growth,” says Merrill Lynch in its preview note on the sector.

At the operating level, brokerage firms expect a mixed scenario across companies. Companies like TCS and Infosys, which declared a wage hike in the previous quarter, are likely to show higher sequential growth in operating profit for the September quarter. This is on account of absorption of salary hikes.

On the other hand, Satyam, Wipro and HCL Technologies are expected to report subdued operating profit since these companies have undertaken salary hikes in the second quarter. For instance, Wipro has given an offshore salary hike between 12% and 14%. “This will impact our operating margin by 160 basis points. Despite this, our broad call is that we will keep our margins flat,” said Wipro IT business CFO KR Lakshminarayana while talking to ET in August.

Analysts are not too hopeful about companies raising their earnings guidance for the current financial year, especially since a recession appears to be looming over the US economy. “Given the economic uncertainty, we believe it is unrealistic to expect Infosys and Satyam to tweak their annual dollar revenue guidance by more than 3%,” says Merrill Lynch.

Citigroup Global Markets too shares the similar view. “Upgrades in earnings per share (EPS) guidance will not be significant in our view due to further rupee appreciation of 2% since the previous guidance.”