Nomura research on Indian IT: MNCs at the gate

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While Indian IT vendors discount the threat of offshore operations by MNCs, trends
suggested by MNC offshore headcount additions are a stark contrast. Our top
BUYs are HCL Tech (well positioned to compete with MNC vendors in deal rebid
scenarios) and Mphasis (a direct play on MNC offshoring aggression). We
downgrade Wipro to NEUTRAL on higher supply side risks and limited upsides.
 Catalysts
Discretionary traction-led pricing and volume upsides could be a trigger for better
stock performance. Rupee appreciation remains a key negative trigger.
Anchor themes
MNC offshore aggression proves the efficacy of the offshore business model, but
long-term continuation of this trend could blunt the definite competitive advantage
of Indian IT vendors, having negative impacts on earnings and valuations.


MNCs at the gate
 MNC vendors more aggressive at offshoring
Top foreign vendors have, on average, added 40% incremental headcount to their
offshore operations vs a 15% addition at Indian IT names over the past six
quarters. In our opinion, this suggests that MNC IT vendors, through aggressive
offshoring, have not only been able to protect their turf, but also offer clients a
value proposition matching or at times even exceeding those provided by top-tier
Indian vendors.
 Indian IT market share gains not at the expense of larger MNCs
Declining revenue market share at the top-five global MNCs would give an optical
illusion that the top-five Indian IT players have gained at their expense. However,
MNC market share losses are due to revenue loss on offshore shift (offshore billing
rates are ~one-third of onsite billing rates). In our view, gains seen in top-tier Indian
IT vendors have come at the expense of fringe players, contractor consolidation
and even other Indian IT players such as Satyam (SCS IN, not rated) (lost ~40% of
its revenue post the accounting fraud in 2009).
 Trend continuation has long-term implications for Indian IT
We believe continuation of the MNC offshoring trend could lead to: 1) inflation of
the employee cost pyramid, and; 2) duplication of the offshore model pioneered by
Indian IT vendors, reducing their competitive advantage. Consequently, over the
long term, we expect the EBIT margin gap between the top-three Indian IT vendors
(25-30%) and MNC (12-15%) to narrow.
 Top picks: HCL Tech and Mphasis; Downgrade Wipro to NEUTRAL
HCL Tech is our top pick, as we see it better positioned to win against the MNC
vendors in large rebid contracts. Among midcaps, Mphasis stands to gain the most
if the above trend is replicated at its parent, HP. We downgrade Wipro to
NEUTRAL on lower comparable growth, higher risks on supply-side pre