Nomura research: IT India:Down Grade Infosys, hold TCS, BUY Wipro and HCL

Turning cautious on stretched valuation / rising macro risks
Post a stock rally of 20 to 55% in the last 1 year, we are taking a more cautious
stance on Indian IT stocks given valuations are at upper end of EV/E to Ebitda
growth band and with risk of macro slowdown in the US, the earnings upgrade
cycle is behind, for now. Historically, Indian IT vendors’ revenue growth has been
correlated with S&P 500 revenue growth, which is forecast to slow in CY11/FY12.
Protectionism could also slow offshoring. That said, current order flow is still
strong, driven by structural & regulatory changes in industries like banking, media
& healthcare, coupled with need for cost optimization. Thereby, we only trim FY12
earnings estimates (Table 1) for the top three vendors, for now.
Infy - lower to Neutral; TCS - limited upside
Lower Infy to Neutral with PO unchanged (6% upside), on stretched valuation,
relatively greater exposure to discretionary IT spend and likely re-investments in
the business, given above industry average margins. Tweak up TCS PO by 5% to
Rs1,050 (12% upside) as we remove our valuation discount to Infy. Also TCS
reaping early investments in BPO & emerging geo’s and could surprise on revs
and margins. Retain Buy. Key risk: slowdown in banking vertical, 35-45% of revs.
Wipro - A non-consensus pick
We prefer Wipro (PO of Rs520, ~20% upside potential) and forecast higher
earnings growth of 21% vs Infy and TCS at 15-17% over FY11-13, given its
dominance in IT infra mgmt services and increasing share in BPO – drivers of the
next wave of offshoring. So, we expect the expanded P/E discount of ~23% to
Infosys to narrow. Our FY12E EPS is 7% higher than consensus. Key risks:
employee attrition, slowdown in manufacturing/hi-tech clients (~25% of revs).
HCLT - A likely re-rating story
We believe HCLT has the potential to be re-rated. We raise earnings by 7% and
PO by 13% to Rs500 (~20%), led by increased confidence in HCLT’s revenue
outlook, given dominance in infrastructure services, improved competitive position
in enterprise applications, and BPO turnaround in sight. HCLT’s earnings outlook
was also helped by improving debt position and falling forex hedging-related losses.
Key risk: Higher-than-guided 250bp investment in margins on wages/BPO in FY11.
September quarter likely strong but discounted
We forecast yet another strong quarter with 6-8% QoQ growth in USD revenue for
the top-four vendors with likely moderating attrition. Expect Infosys to have the
strongest quarter on both revenue growth and margin expansion, since the wage hit
is behind it. Believe commentary will be positive but guarded on FY12, given low
visibility into CY11 budgeting cycle. Do not expect any meaningful guidance raise.
HCLT will likely have the weakest quarter given wage hikes and BPO investments.