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IT (Global growth, revival in discretionary spending reaping
benefits, rich valuations) Positive
The IT sector had a favourable year led in part by strong volume growth as
clients across continents continued to spend top dollars on driving
efficiencies through IT. Business spending revived adequately but wage
inflation and attrition worries continue. Negotiations for upward price
revision bode well and could tame wage inflation. Discussions with Tier-I
vendors suggest CY11 budgets could have a positive bias towards
discretionary spending and off shoring within outsourcing. Consequently,
we believe, CY11 could be a year of discretionary spends led earnings
upgrade. We expect Tier-I companies to outperform Tier-II ones as they are
better positioned to manage operational headwinds such as currency,
attrition and wage inflation. Thus, TCS and HCL Tech remain our top picks.
⇒ Save to spend.
We analysed Corporate America’s health between CY04-CY10.
Noticeably, cash and liquid assets of S&P 500 constituents are at its
peak while capex as a percentage of these assets is near its trough.
This suggests efficiency could drive productivity gains given the bleak
outlook on new capacity additions, which bodes well for IT spending
⇒ M&A integration induced discretionary spending could persist
Analysing M&A transaction volumes since CY98 suggests transaction
volume peak-trough cycle endures for an average of 10 quarters.
Evidently, in FY05-FY10, Accenture’s (ACN) consulting bookings
growth declined significantly in FY09, the same year when M&A
transaction volume bottomed. Further, note that consulting bookings
typically have long conversion cycles compared to outsourcing
bookings. Appreciating that M&A integration led discretionary
spending accelerated in FY10, a favourable consulting bookings
growth guidance for FY11 by ACN augurs well for Indian vendors
considering their revenue contribution from these services continues
to rise.
⇒ Consulting/system integration revenue contribution on the rise
Tier-I Indian IT vendors who have historically relied on the linear model
for volume growth continue to see a jump in revenue contribution
from system integration and consulting services
⇒ Valuation qualms: Historical analogy may allay concerns
We analysed historical revenue and EBITDA margin out-performance
of Tier-I Indian IT vendors (TCS, Infosys, Wipro and Cognizant) vs.
Sensex companies coupled with the average P/E premium. Tier-I IT
companies have traded at a premium to the Sensex due to their
superior revenue and EBITDA growth. Peak P/E premium was 52% in
FY07 while lowest was 3.1% in FY09. We expect this out-performance
to continue in FY11 and FY12 leading to a widening of the P/E gap.
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