Goldman Sachs: Initiate on Patni with a Sell rating, Rolta with a Neutral

Initiate on Patni with a Sell rating, Rolta with a Neutral
We initiate on two mid-cap IT companies, Patni Computer Systems (PTNI.BO)
with a Sell and Rolta India (ROLT.BO) with a Neutral rating. We believe that
Patni’s lower exposure to high growth services will lead to a modest 9%
revenue CAGR over 2009-2012E vs. the sector at 15%, resulting in flat earnings
growth and fourth quartile cash returns over the forecast period. Our 12-m
Director’s Cut based TP price for Patni is Rs391, implying 13% potential
downside. On Rolta, we believe that despite 14% earnings growth, high capex
and leverage will diminish cash returns over the forecast period resulting in a
balanced risk/reward profile with limited upside. Our 12-m Director’s cut-based
TP for Rolta is Rs182.
We prefer large cap stocks in our coverage, Buy TCS, HCL Tech
Following the sector's underperformance in the first half of 2010, we began
advising investors to increase their sector exposure in June and highlighted
large-cap stocks like TCS and HCL Tech, both Buy-rated. We expect the
revenue momentum to continue to be stronger for the industry leaders. We
believe that amid concerns on sustainability of the economic recovery, belowtrend
tech spending growth in 2011, attrition, and wage pressures, large-cap
Indian IT services firms are best positioned to come out ahead of mid caps due
to scale advantage and will likely generate higher cash returns within our
coverage universe. We prefer TCS and HCL Tech as our top picks in the sector.
Mid caps offering low cash returns, trading at historical valuations
After a significant outperformance in 2009, both Patni and Rolta have
underperformed the broader market ytd (by 23%/25%) and the Indian IT
services sector (by 13%/15%) primarily on the back of weaker quarterly
earnings and outlook. We forecast this trend to continue.
On valuations, Patni is trading at 11.6X P/E on CY11E EPS, in line with its sixyear
historical average and mid-cap multiples. Our TP is at a 17% discount to
mid-cap peers, which we believe is justified considering the muted outlook and
stagnant cash returns. Rolta is trading at 8.5X on FY12E P/E, in line with its 6-
year historical average and at a 26% discount to mid caps.
Key risks for the sector
Upside: Return of discretionary spending, stronger-than-expected economic
recovery. Downside: currency volatility, wage inflation and attrition, slowdown of
economic recovery in the US/EU.