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Key sector dynamics: Undiminished revenue
momentum in FY12 is key to sustaining valuations
As FY11 marks the strong revival in technology services
spending, Indian IT Services bellwethers TCS and
Infosys are likely to end FY11 with 25%+ US$ revenue
growth. What’s more, companies’ tentative
pronouncements on CY11 IT budgets of their clients
carry a positive, optimistic tone to them. This creates
confidence in sustained revenue growth exceeding 25%
in FY12E for select players. It could be close to even
30% if strength in the US holds up.
Growth characteristics and how they are changing:
The nature of IT spending is changing as different
drivers have emerged. In our view, almost every vertical
has several different drivers emerging today which may
not have been in fashion/existence pre-crisis but gains
should accrue only selectively to vendors. The top-tiers
such as TCS/Infosys are impressively expanding their
addressable market and they are not doing it just by
expansion into new verticals but doing that within
existing verticals/clients. There is a tide in demand for
sure but this is selective and not one that lifts all boats.
Cost pressures likely to moderately ease in FY12 as the
bias in the hiring mix moves towards freshers away
from laterals. However, we do need pricing upside to
hold margins at current levels through FY12 on an
annual basis as margin relief by broad-basing the hiring
pyramid is limited to within 100bp.
Drivers of returns - multiples and growth
Confidence in FY12 is higher now because of
discretionary spending ticking up nicely in addition to
cost-cutting and cost-restructuring considerations.. Yet,
in our view, stock upside still remains limited to ~10-
12% over the next 12 months (Sep-11) given
expectations of near-30% USD revenue growth in FY12
embedded in the stock prices of TCS/Infosys.
Recommendations
We continue to be skeptical of the sustainable return
potential of the generic IT mid-cap for good reasons.
TCS (OW) remains our top pick. It is the only company
for which we have upgraded FY11/12 EPS estimates
through all the three quarters of CY10 thus far and
perhaps presents the best case for earnings upgrades and
thus stock upsides despite high expectations. HCL
Technologies (HCLT) is now trading 35-40% discount to
Infosys on valuations and represents a near-term
opportunity because we expect the discount to narrow on
the back of improving margin performance.
Stocks to avoid – Wipro, Satyam.
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