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India: Technology: IT Services
Equity Research
2011: Revenue momentum accelerates; bias towards large-caps
Outlook for global tech spending brighter; Indian vendors to gain
We turn more constructive on large-cap Indian IT firms for 2011, despite
the stronger revenue base of 2010. We raise our FY2012 revenue growth
forecasts to 23% for the top four firms (INFY, TCS, WIPR, HCLT), estimating
incremental revenues of US$ 11.5bn over next two years. This is based on:
(1) GS economists’ US GDP forecasts (3.4%/3.8% in 2011/12); (2) our higher
global tech spending forecast of 6% for 2011; (3) Ongoing tech investment
in the BFSI vertical (4) US$ appreciation vs. major currencies (incl INR). In
our view, this outlook is fairly rewarded, with large-caps trading at 21X
FY12E P/E. We favor HCLT (Buy) on its sector topping 3-yr EPS CAGR of
27%. We are Neutral on Infy, TCS and Wipro, but would add to positions on
any weakness. We lower Mphasis (MBFL.BO) to Neutral, owing to recent
price performance leaving limited upside to our TP and maintain estimates.
Raise revenue forecasts for Indian IT; up to 8% above consensus
We raise our revenue estimates for the four large caps 1%-14% in FY11EFY13E,
and EPS by 2%-16%; mostly due to our new 24% constant currency
growth (from 21%). Our forecasts are up to 8% over Bloomberg consensus
and we expect quarterly results to drive earnings upgrades going forward.
We raise our 12-month Director’s Cut-based target prices by 17%-30%.
BFSI still driving growth; Retail and Healthcare to contribute too
We expect the BFSI vertical also to be a key growth driver in 2011. As M&A
integration work tapers off, we expect increased regulatory and compliance
spending to drive IT spending. TCS remains best positioned and we expect
INFY to match TCS’ 25% BFSI growth rate for FY11E. We expect Healthcare
and retail (15% of revenue) to grow at similar rates in 2011/12.
Currency holds the key; further upside potential from FX rates
The large caps are trading at 21.6X FY12E P/E (in line with their historical
average); and so, despite 22% revenue CAGR in FY10-FY13E, valuations
offer limited upside. Company managements have highlighted currency as
the single largest risk for 2011. We use a rate of Rs45/US$ for FY12E (from
Rs43); below GS ECS forecast of Rs47 to narrow potential FX volatility.
Assuming Rs47 would add up to a further 6% upside to our valuations.
Key risks
Significant INR appreciation, high attrition, US/EU economic slowdown.
Demand outlook stronger into 2011; margin headwinds receding
Multiple positives drive earnings upgrade; raise EPS by 2%-16%
The large cap stocks under our Indian IT services coverage have outperformed the broader
Indian market since the beginning of 2010 (up 35% vs. BSE-30 up 15%) despite multiple
headwinds such as concerns about global macro and IT demand outlook, margin pressures
due to wage hikes/attrition and volatile currency. We believe that most of these concerns
have materially subsided and expect the Indian IT sector to continue to outperform over
the next 12-18 months.
Based on a blend of macro and company specific factors, we are raising our revenue and
EPS estimates for the large cap companies under our coverage. We also incorporate the
current exchange rate of Rs45 per US$ for FY12 (from Rs43). We note that as per our GS
Economists, the 12-month INR/US$ exchange rate forecast is Rs47, which could provide
additional upside to our EPS estimates. We raise our revenue forecasts by 1%-14% and the
EPS estimates by 2%-16% for FY11E-FY13E. This translates to an incremental revenue
addition of US$ 11.5b over the next two years for the four large-caps. As a result we also
revise our Director’s Cut-based 12-month TP for these stocks by 17%-30% (incl. ADRs).
We favor HCL Tech (Buy) on its strong earnings growth outlook and relative
undervaluation. Despite recent outperformance, the stock is still trading at 14.2X on FY12E
offering the highest 3-yr EPS CAGR of 27%. We are Neutral on Infosys, TCS, and Wipro,
but they are looking more attractive based on valuation.
We downgrade Mphasis (MBFL.BO) to Neutral, owing to its recent price performance,
leaving limited upside to our TP. We maintain our estimates and TP for Mphasis. This is in
line with one of the key themes identified from our IT services trip, where we see the
outlook being more challenging for small and mid-cap companies, which have scale
limitations. Hence, with similar upsides from large-caps and mid-caps, we are biased
towards large cap stocks.
1. Bottom-up visibility being matched by improving macro outlook
Improving macro economic outlook; US to lead recovery in 2011: Our GS ECS
Research recently increased its US GDP growth forecast for 2011 to 3.4% from 2.0%.
We believe that this is directly beneficial to Indian IT companies as about 60% of
revenues for our coverage universe is derived from the US.
Global tech spending outlook turning brighter: The GS tech team has increased the
global IT spending growth forecast for 2011 to 6% (from 5%) to reflect the improving
macro environment. We believe that increased tech spending would likely translate
into companies investing more into enterprise system upgrades, which will also
directly benefit the Indian IT sector.
2. GS IT trip confirms continuing investment into Tech by clients
Following our IT services trip in December we are more confident that secular growth
of offshore services will continue and that the demand outlook remains robust.
Company managements we met with were unanimous in confirming a robust demand
backdrop and expected intact budget cycles, with upside risks heading into 2011. The
deal pipeline at Indian IT services companies, particularly large caps, remains healthy.
3. Risks skewed to the upside; INR depreciation key upside risk
We believe the risks to the sector are skewed to the upside — as the recent cycle of
wage hikes and elevated attrition is nearing normalization and we expect reduced
margin headwinds going forward. As companies refocus their hiring strategies
towards increased campus hiring, we expect pressure on operating margins to ease.
Also, GS ECS forecasts the INR to depreciate to Rs47 in the next 12 months. However,
we build in a rate of Rs45 to the dollar to reduce potential FX volatility in our estimates.
We build a scenario analysis around our FY2011E-FY2013E earnings and our Director’s
Cut valuation — based on one rupee increments above and below our base case of
Rs45/US$. At the top of our range, using GS ECS FX estimates our Director’s Cut
valuation rises offering an additional 5%-6% upside from current prices (depending on
the operating profitability and revenue breakdown of different companies).
4. Focus to be on revenue growth, rather than earnings growth
As IT firms deliver strong operational performances through the course of 2011, we
expect the focus to be on revenue growth over the near-to-medium term, as we believe
that the operating leverage thesis has played out. Furthermore, we believe the effect of
the rise in tax rates in muting earnings will not be a significant deterrent to stock price
performance. We also believe that the large-cap companies are likely to outperform
mid-cap players, as mid cap companies grapple with challenges of recruiting and
retaining talent, face greater pressure on operating margins, and have scale
disadvantages.
Brighter economic outlook in DMs provides stable foundation for IT
GS ECS team forecasts US Real GDP growth of 3.4%/3.8% for 2011/12
Recent data points coming from the US suggest a better-than-expected macro economic
outlook for 2011. Our GS ECS Research has increased its US Real GDP growth forecast for
2011 to 3.4% from 2.0%. This is above Bloomberg consensus of 2.7%, for the first time in
the last five years.
The GS ECS team has also increased US capital spending growth forecasts for 2011 to
7.9% from 5.9%. As per our US strategy team, S&P 500 corporate profits in 2011 are now
estimated to grow at 11.0% (from 8.7% earlier). The ISM index has been on an upward
trend since September 2010 after a sudden cooling-off in mid-2010.
Our proprietary GS Analysts index has also remained stable over the last three months,
reflecting the improved economic outlook for the US. We believe that the improving
economic outlook in the US over the last few months augurs well for Indian IT as the US
accounts for more than 60% of revenues for companies in our Indian IT services coverage
universe.
Global tech spending forecast for 2011 raised to 6%; discretionary
spend likely to return
On the back of our above consensus GDP outlook for the US (and RoW), our GS global tech
team has increased its global IT spending growth estimate for 2011 to 6% (from 5%). While
the 2011 estimate is still lower compared to the robust growth of 9% in 2010, we believe
that a disproportionate part of the spending growth in 2010 can be attributed to the
spending delayed from 2008 and 2009 due to the global economic slowdown.
The 2011 estimate is still below trend due to likely tightness in government spending in
developed economies (government spending is estimated to represent around 15%-20% of
total global IT end demand), which would have minimal impact on Indian IT Service
companies as Indian vendors mainly cater to the private corporates in the region.
While much of the growth for Indian IT in 2010 can be attributed to the pent-up demand,
we believe that a recovery in the discretionary spending component is essential to sustain
the growth momentum. We expect an increase in discretionary spending to lead to an
enterprise system and technology upgrade cycle, directly benefitting Indian IT companies.
We believe that Infosys, TCS and HCL Tech are best positioned in the Indian IT sector to tap
into the improved global IT spending environment.
We estimate incremental revenue of US$5.3bn/6.2bn in 2011/2012
Raise revenue forecasts as growth momentum set to continue in 2011
While 2010 was the year of a reset for Indian IT, we believe 2011 will be a year to build on
the momentum from 2010. Over the next two years, we forecast the top four companies in
our coverage universe to add incremental revenue of US$5.3bn and US$6.2bn in 2011E and
2012E. This translates to a three-year revenue CAGR of 21% over FY2010-FY2013E.
BFSI projects to drive growth; biased to Healthcare/Retail exposure
Banking, Financial Services and Insurance vertical (BFSI) has been the single largest
vertical driving growth for IT vendors over the past few years, albeit with a hiatus in
FY2009 due to the global economic crisis. BFSI growth in FY2009-10 was attributable to
M&A related integration work as well as regulatory compliance work.
While there have been expectations of growth in this vertical cooling off, we believe that
new projects arising from regulatory changes (related to Basel Norms etc) & restructuring
in financial systems will drive investment into tech spending. TCS continues to benefit
from the surge as it has the highest exposure to this vertical in our coverage group (45% of
revenue in FY2010). Infosys has also increased its revenue share from BFSI over the last
two years from 33% to 35.5%; and we expect both INFY/TCS to grow it at 25% in FY2011E.
Among other verticals, retail and healthcare are the other two areas where, in our view, we
will see a significant investment into software spending (15% of revenues for the top-four
Indian firms). Companies are increasingly focused on investing in these two verticals —
which has resulted in a strong pick-up in revenue growth in these verticals (fastest growing
verticals in 2QFY11). We expect the Retail vertical to be driven by return of consumer
confidence in the US economy and consumer spending (Exhibit 8). Healthcare should be
driven by the regulatory changes and implementation of the healthcare bill as well as the
genericization regime, in our view.
Despite peak OPM of 23.6% in 2010; OPMs could be sustained in 2011
While many concerns have been raised about the sustainability of margins given the
downward trend in pricing, rising wage costs and employee churn, we believe operating
margins will be sustained over FY11E-FY13E as companies use operating levers like
utilization and higher offshore mixes to sustain margins. While net profitability is likely to
be negatively impacted starting from FY2012E due to cessation of STPI tax benefits, we
expect the sector to still post a net income CAGR of 18% over FY10-FY13E. While currency
fluctuations remain a major source of uncertainty, we believe companies are better
prepared to handle adverse movements than they were in 2007 due to the multiple
operating levers at their disposal.
Tax rates to differentiate on EPS growth in FY12, INFY is best placed
With the sunset clause ending in FY12E, effective tax rates for the sector are set to increase
by 400-600 bp in FY12E. This will have a negative impact on EPS growth, which would be
muted in comparison to revenue growth. In our view, Infosys will be the least affected as
its effective tax rate is already at 25% and 80% of its income is taxed at corporate tax rates.
Expect 2011 price performance to reflect revenue growth, not EPS
Over the past year, the rally in the IT stocks has been a reflection of improved revenue
outlook for the sector — despite margin headwinds from labor costs and currency and
increasing tax rates. We expect price performance in FY2012 to remain a function of
revenue upgrades rather than EPS as the IT sector faces an end to tax benefits and EPS
growth remains capped by this.
Rich valuation for large-cap firms reflects strong growth prospects
We are incrementally positive on the sector given the improved macro and tech spending
outlook and increased confidence in the secular demand growth that we identified on our
IT trip. The Indian IT sector has historically traded at a premium to the broader market (28%
premium vs. MSCI India) although this premium had narrowed to 13% during the global
economic downturn. Despite the recent rally in stock prices of the IT companies, the large
cap sector is still trading largely in-line with its historical premium to the MSCI India index
(Exhibit 29).
We believe that with revenue growth on a sustainable trend for the sector, the valuation
premium to the broader market will increase from the current levels and therefore provide
meaningful upside, even at current levels. We also believe that reduced profitability due to
increase in tax rates is unlikely to dampen valuations as historically the sector has traded
more on revenue growth rather than earnings growth (Exhibits 28-29).
On the back of significant earnings upgrade, we raise our 12-month Director’s Cut-based
target prices for the large cap stocks by 17%-30% (including the ADRs).
Potential INR depreciation — further upside potential of up to 6%
Our Global ECS Research team has revised its 12-month INR/US$ forecast to Rs47 (from
Rs43). However, we base our estimates on Rs45/US$ for FY12 to reduce volatility in
estimates due to potential high volatility in the foreign exchange rates.
We build a scenario analysis around our FY2011E-FY2013E earnings and our Director’s Cut
valuation — based on one rupee increments above and below our base case of Rs45/US$.
At the top of our range, using GS ECS FX estimates our Director’s Cut valuation rises
offering an additional 5%-6% upside from current prices (depending on the operating
profitability and revenue breakdown of different companies).
Bias towards large-caps as clients and talent seek them out
Over the last 12 months, the Indian IT services sector has been characterized by a
divergence in the valuation for large cap and mid cap companies. This has been on the
back of robust volume and earnings growth for large caps despite a much-higher base.
Going into 2011, we believe that the valuation gap will widen as:
Scale and Service limitation for smaller firms are placing them at a disadvantage:
On the demand front, we believe, mid-cap companies are finding it difficult to compete
on large deals due to lack of scale. Post recession, many clients are seeking to
consolidate their IT vendors in order to reduce costs and overheads. This has placed
the smaller firms at a disadvantage as their portfolio of offerings and scale are limited
and not large enough to provide the entire spectrum of outsourcing services
(Consulting, IT, BPO etc). We believe that this trend is here to stay and expect more
clients to look for one-stop shop services for their IT requirements and thus prefer
large cap companies except for certain niche services in specific verticals.
Higher recruitment and retention costs hurting margins for mid-caps:
Mid cap companies have also suffered on margins due to significant wage pressures
and elevated levels of staff attrition. Many mid-cap companies we met during our IT
trip last month suggested that availability of talent at appropriate cost levels was
becoming a cause for concern. We believe that these margin pressures are going to
persist for the next few quarters as demand-supply deficit remains unfulfilled,
especially in the middle experience group (3-5 years experience) due to lack of hiring in
2008-2009.
Implications for 2011 from our India IT Services Trip (Dec 2010)
Last month, we visited around 20 companies across a wide spectrum of IT services delivery
models over four cities. Our trip provided us with increased confidence that the secular
growth trajectory is intact for the Indian IT service providers. We believe that the forces
driving offshore and global service delivery remain strong and this should fuel
outperformance for selected names with exposure to this trend. Key themes coming out of
our trip are:
(1) Offshore remains a key secular growth area in IT service delivery
While we believe that a portion of the growth experienced in 2010 was a function of pentup
demand and the cyclical recovery of IT spend, we also attribute much of the growth to
favorable secular dynamics. Specifically, from an addressable market perspective the
absolute penetration of offshore remains low. Bearing in mind the latest estimates by
India’s technology trade association NASSCOM which suggests a total market opportunity
of $300bn-$400bn with current industry revenues sized at $50bn-$60bn, the absolute
penetration for offshore services remains well under 20%. In addition, the addressable
market opportunity is expanding as offshore companies target new service offerings (e.g.,
infrastructure, BPO, consulting, etc.) and focus on penetration of new markets (e.g.,
Australia/New Zealand, Latin America, China, etc.). At this point, offshore’s value
proposition is firmly cemented as an integral part of service delivery models as enterprises
continue to grapple with operating cost constraints and the need to invest in new growth
initiatives and technologies
(2) Intact budget cycles and pipelines drive high confidence into 2011
Demand commentary from the companies that we met with was unanimous with all
companies confirming a robust demand backdrop into the end of 2010. When we pressed
the companies on expectations for 2011, the commentary was consistent in echoing our
expectations for sustained growth, with most basing their growth expectations on normal
budget cycles and intact pipeline efforts into next year. Anecdotal commentary suggested
that visibility into 2011 was better at this point when compared to same point in time in
2009 and looking ahead to spending intentions for 2010.
(3) Labor dynamics likely to stabilize in 2011; hiring back to campus mode
One of the more concerning trends over the last two quarters has been the marked uptick
in employee attrition for nearly all companies in the space. It was a function of the rapid
snapback in demand, with most companies caught unprepared to meet increased demand.
As such, in our view, there was a spurt of increased lateral hiring or outright poaching of
competitor employees to meet client requirements.
Based on our conversations, it appears that many of the factors that drove attrition higher
have normalized. Although demand backdrop remains high the supply planning cycles
appear more appropriately tuned, with most of the companies we met with indicating that
the worst of employee attrition was now behind them. Given the large supply of new
campus graduates, there appears to be ample labor supply to meet demand requirements.
However, some of the smaller companies that we met with did express some concern
about being able to find, recruit, and retain the right talent.
(4) Wage inflation cycle expected to normalize into 2011
Following two years of relatively stagnant wage increases and promotion cycles, 2010
experienced a higher level of wage inflation; however, much of this appears to have been a
function of catch-up as well. Into 2011 it appears that most of the companies are planning
for a more normal wage cycle with average wage inflation expected to finish up in the 10%-
15% range. On balance, however, we noted more concerns about wage inflation from the
smaller companies we met with, where more explicit concerns about their ability to
manage growth and meeting hiring requirements was expressed.
(5) Currency seen as the biggest risk factor for next year
Indian offshore service providers cite currency volatility as the single largest risk over the
next year. Due to increased volatility in the currencies (USD, GBP, EUR, JPY, AUD, and INR)
over the past two years, companies have moved towards shorter horizons for hedging their
currency exposures. Some companies have even stopped taking hedges due to increased
uncertainty over the direction of currencies. Managements maintain that small moves in
currencies can be managed over a period of time but material fluctuations pose risks to
margins. With fluid economic conditions in EU and dynamic fiscal and monetary situation
in India, cross currency exchange rates and INR continue to pose risks and uncertainty over
margins and profitability.
(6) China remains an opportunity and a threat; but remains nascent
Consistent with the findings of our recent trips to China, we found little evidence that this
market is ramping up ahead of our expectations. Most of the companies are very early in
their efforts to scale this market. Clearly the domestic opportunity in China is large,
however, the track that most seem to be pursuing in China is to use it as development and
support center for their broader Asia efforts including servicing Japan and other countries.
From a competitive perspective, China is the only country with the labor supply and talent
to compete effectively against India, and therefore we expect that its prominence will only
continue to rise as current efforts by the Chinese government to improve language skills
and expand capabilities as they eventually take hold.
(7) Long-term BPO growth intact, but demand trends appear lumpy
Long-term secular growth for offshore BPO remains intact, with most companies citing
BPO as one of the top areas of ongoing investment and recruiting. That said, demand
trends will likely remain lumpy in the near term, as customers appear to be focusing on IT
and faster payback projects that require less upfront investments. Similar to IT, the focus
on offshore BPO services appears to have shifted from pure cost arbitrage to business
outcomes. As such, factors including domain expertise, process excellence, the ability to
leverage technology to enhance operating efficiencies, and project management skills will
be paramount in ensuring the long-term success of the BPO model and become major
differentiating factors among service providers.
(8) The nature of competition is changing to the front end
In what was the most clearly articulated perspective during our trip, the CFO of one of the
companies we met with made the point that in order for offshore vendors to survive long
term commoditization they needed to change their selling approach “order-taker mentality,
to one of a demand generator.” Against this backdrop, the companies we met with
articulated various strategies to further develop front-end capabilities including a focus on
consultative selling driven by client partner models. In general, it appears that most of the
companies have concluded that demand generation will require a new value proposition
heavily dependent on improved industry and domain expertise and more effective account
management to drive more effective client penetration.
(9) Non-linear growth mantra continues to evolve; but still early
It has been a few years since the concept of non-linear growth was first articulated as a
requirement for the long-term viability of offshore models that remain heavily dependent
on pure labor growth and head count additions to drive revenue growth. Despite much talk
of moving to non-linear models these efforts remain relatively early, but the imperative to
shift to non-linear growth remains high as some of the larger companies in the space have
now broken over 100,000 employees and a few well on their way to the 200,000 barrier.
From a revenue contribution perspective non-linear revenue contribution remains well
under 10% and mostly relegated to smaller software product offerings. That being said, the
prospects for non-linear models remain high and appears to be taking on many forms with
companies continuing to explore a range of delivery options including platform-based
solutions, managed services, and point solutions with SaaS-based delivery.
(10) New services and markets key to long-term growth initiatives
Looking ahead, further penetration of services in addition to the successful ramp of new
services offerings in knowledge process outsourcing and analytics will be key for sustained
growth opportunities. Interestingly, in our trip there was some debate and disagreement
among the companies we met with about the relative importance of consulting as an
addressable growth area and this was a point which was clearly inconsistent with the
requirement to move to higher value selling and deeper industry/domain expertise
requirements.
(11) Near-term drivers are anchored on non-technological drivers
While the secular context for offshore’s long-term growth potential are well understood,
the near- to medium-term drivers for the industry’s growth profile are anchored on both
macro forces and non-technological forces with regulatory/compliance efforts at the top of
the list. Consider the following:
From a macro perspective, we continue to see a clear dichotomy in performance with
the US and emerging markets driving the majority of global growth expectations.
Although the US economy continues to face challenges, US corporate profitability (as
measured by the S&P 500 companies), remains strong and provides a positive bias to
technology spending; with 70%-75% of revenues derived from US companies this
remains the key market for sustained growth prospects of offshore models.
While labor trends remain sluggish overall with relatively weak hiring trends and high
unemployment, labor constraints and resource availability for IT resources continues
to fuel demand for offshore labor. Finally, we believe that the protracted nature of the
recent downturn has forced many large enterprise to further contemplate global
services delivery as cost efficiency, below trend budget growth, human capital
constraints, and the need to invest in new growth initiatives and technologies
resonates well with offshore’s value proposition.
Changes in regulations and new compliance requirements are driving clients to
revamp systems and processes; this is most relevant in the financial services industry
which remains the largest end-market, contributing 30%-35% of industry revenues.
Healthcare reform in the US was also cited as an important driver for new tech
spending as companies revamp systems to conform with new reporting requirements
for employees and health care provisioning. Post-M&A integration continues to
provide an important driver as enterprises drive system and consolidation efforts.
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