Accelerated decision-making cycle led to a surge in volumes in the third quarter, which has driven our optimism on the information technology (IT) sector. Further, as vendors chart out 2010 budget discussions with their clients, visibility has increased. Client seeking cost relief change their delivery mix towards offshore options. While clients’ focus predominantly remains on cost takeouts, IT vendors are also seeing demand for projects focused on strategies for revenue growth, which is a positive signal.

Graphic: Ahmed Raza Khan/Mint

On reported basis, the pricing (realizations) may see a modest rise. We do not expect this result season to see earnings upgrades as in the past two quarters. Also, this quarter we do not see Tata Consultancy Services Ltd (TCS) outperforming Infosys and Wipro Ltd the way it has consistently done in the past three quarters.

We expect the firm to guide to dollar revenue growth of 11-13% (after 1.5% cross-currency effect) and earnings per share (in rupees) guidance to be around 120 for FY11, implying 10% growth. This may result in near-term weakness in IT stocks as the Wall Street (including us) pegs growth at 20-22%. Further, we note that Infosys may base its guidance at exchange rate (not considering the quarter-end rate due to sharp appreciation at the end of the quarter). However, Infosys may do the balancing act by announcing a special dividend (as it has done every alternate year in the past).

Volumes are expected to be modest for most tier-2 companies with customer-specific events taking a toll on their revenues.

Rupee appreciation will have a significant effect on companies, such as HCL Technologies Ltd (3.0%), InfoTech Enterprises Ltd (3.6%) and Hexaware Technologies Ltd (3.0%), on rupee revenues and 1.6-2.2% on dollar reported revenues. The earnings before interest, tax, depreciation and amortization margins, sequentially, are expected to decline across companies (higher for tier-II) due to rupee appreciation across major currencies.

We see valuations (Infosys at 21 times FY11 estimates, Wipro at 20 times and TCS at 21 times FY11 estimates) capturing most upsides fairly adequately. Mid-caps, in our view, will continue to trade at 50% discount to large peers, given low revenue growth visibility. For companies where revenue growth visibility is likely to return may see re-rating from subdued valuations (as we saw in the case of Infotech). TCS and Infotech remain our top picks in the sector.

A key concern is increase in attrition and wage hikes, which, in our view, is a normal phenomenon as the sector sees brighter prospects going into FY11. We do not see any hurdle due to higher attrition. Another risk that has got elevated of late is the appreciating rupee due to its pace of appreciation. Though we have factored in Rs45 per dollar for FY11, appreciation from the current levels will weigh heavy on earning for all companies. For mid-tiers, rupee appreciation will affect financials materially, except for those where hedge positions are significant.