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India IT Services
In times of the new normal, beware of the reversion to mean valuation theory
• The Indian IT industry has picked up the reins of growth in CY10 – this looks
set to continue with a good outlook for CY11/FY12 as well. Traditionally, over
FY04-08, the industry characteristics have tended to be stable/predictable and
the positioning of the relative players therein relatively defined in terms of
growth/margins.
• But with the new normal beckoning for the Indian IT industry, individual
players may also have to contend with the new normal and thus new valuations.
This will have implications, in our view, for prospective valuations (P/Es) which
may bear little correlation with those in the past. When the industry tends
towards a new normal, companies whose characteristics (e.g. growth, margins
etc.) change also face a new normal in the context of the changing industry. In
such a case, we see the reversion to mean valuation as less of a likelihood (as
newer secular factors have emerged) and in the worst case an unreliable
valuation argument.
• Within the top-4 Indian IT companies, we cite the case in point of TCS
versus HCL Technologies. If the reversion to mean valuation theory plays out,
then HCL Technologies (HCLT) should re-rate and TCS should de-rate (hence,
play the pair trade according to some long-short investors). This is because in
the past 5 years to date (or over a full cycle), HCLT has traded at a 5 year
median forward valuation discount of ~22% to Infosys (P/E) and the discount is
now 30%+. TCS, on the other hand, at 23x one-year forward P/E which stands
at a 20-25% premium to its 5-year median forward P/E.
o In our view, this argument may not hold if the significant improvement in
TCS seen in its revenue/margin profile is structural and enduring (which
we believe is the case). On the other hand, HCLT's current valuation
discount to Infosys' at 30%+ may not revert to the historical median
discount of 20-22% if the EBIT margins of this company are seen
structurally weakening and attain the level of new (normal) normal. This
newer normal which we estimate at 15% is appreciably lower than the
average EBIT margins during FY05-08 of 17-18%. Hence, we are not in
agreement with this thinking when companies structurally change.
• The reversion to mean valuation discount is normally cited in the case of
Indian IT mid-caps - As a pack they are generally trading at valuations 40-
60% below TCS/Infosys. That said, competing today on growth/margins has
also become more difficult for them (more so the undifferentiated, generic midcap). For this reason, we are more careful about using the reversion to mean
valuation discount theory in citing investment opportunities in Indian IT in the
mid-cap space.
• Investment conclusion. TCS (OW) remains our top pick in the sector.
Valuations at 22x FY11 seem stretched but we believe that TCS can still
surprise on earnings even more than it has already done right through FY10/11
through a combination of revenue/margin upgrades.
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