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Technology
India
2QFY11 review – more of the same. Even as 2QFY11 earning reports delivered an
unequivocal verdict on the strength of the demand environment, forcing US$ revenue
upgrades, revised Re/USD assumptions kept EPS upgrades in check. We stick to our
‘play growth, be wary of margins’ thesis, maintaining our bias towards Tier-I names,
TCS and Infosys in particular. Among the mid-caps, we upgraded Hexaware to a BUY
on robust revenue outlook, low margin risks and inexpensive valuation.
Sector view – stay positive on demand, wary of margin/attrition pressure; Tier-Is better positioned
We remain positive on strength and sustainability of demand upturn for the Indian IT services
industry. We see sustainable (in the medium-term) demand tailwinds building up in the form of
improving pace of decision making, greater conversion of IT budgets into spends, release of pentup
discretionary spend, gains for the offshore players in vendor consolidation instances, and
improved deal flow across most verticals. We do not rule out further revenue upgrades, despite
meaningful ones post 2Q earnings reports – a stable Re would translate the same into earnings
upgrades as well.
We would prefer to play the strong demand through Tier-I names (Infosys and TCS). We do believe
it is time to turn positive on select mid-caps meeting twin criteria of (1) good volume outlook and
(2) low risk to margins. However, we do not see most mid-sized companies passing the ‘low risk to
margins’ filter, for now (please see our note dated October 15, 2010 for detailed thoughts on this
aspect). We have upgraded one mid-cap which does – Hexaware (please see our upgrade note
dated October 29, 2010 for details). We remain cautious on other mid-caps.
Relative growth is the only margin lever in the high-growth environment
2QFY11 earnings report also drove home another critical and often under-appreciated facet of the
current industry environment – margin protection is a function of relative growth. Companies that
grew faster than the industry (notably TCS and Infosys) reported better margin performance than
the companies that grew slower (notably Wipro). The underlying reason for the same is
fundamental and yet missed out a lot of times – in a supply-constrained high-attrition high-growth
environment, companies have little control on wage levels. The need to match industry
compensation levels is high and low growth has flow-through impact on margins, given little cost
discretion. Pulling traditional margin levers (employee pyramid, utilization, offshore mix) is typically
not the primary focus of management teams in high-growth phase and hence, extent of
participation in growth assumes even greater significance.
Demand – find issues/ challenges/ faults if you must, we focus on fundamental strengths
Naysayers and skeptics could point at macro uncertainty, weak quarter for large US banks,
protectionism and other issues possibly, but we focus on what we believe are two fundamental
forces behind demand strength for the Indian IT services companies – (1) secular off-shoring trend
– expected counter-cyclicality failed to play out during the downturn as clients froze decision
making but the trend has made a strong resurgence in the past few quarters and is likely to
sustain in the medium term, in our view, and (2) wider and deeper acceptance of the Tier-I Indian
IT companies (TCS, Infosys, CTS and Wipro) as true IT transformation partners, a clear up-move
from just a credible cost-reduction alternative. We have been believers in the strength of the
demand environment and the Tier-I players’ ability to capture the same—2QFY11 earnings reports
from companies in the sector add to our conviction.
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