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Indian IT Services
We recently had conversations with IT bellwethers TCS, Infosys
and Wipro to get a business update. Understandably, a cautious
stand was the order of the day due to short-term spending visibility
from clients. However, near-term growth commentary was
reassuring driven by strong spending momentum, discretionary
up-tick, continued offshoring sentiment and improving pricing
power. All three companies expect CY11 client IT budgets to be
finalized marginally higher and more importantly on time. Key
concern expressed was high lateral attrition impacting smooth
execution of growth. We maintain positive stance on Indian IT sector
with distinct bias towards Tier-1 companies as mid-cap players
may take some more time to fully participate in the recovery. Despite
the recent rally, we believe the large IT stocks provide value as
valuation has shifted to FY13. Amongst the Top 3, we are relatively
more bullish on Infosys and TCS.
Demand environment remains sanguine; increasing
propensity for offshoring and outsourcing
The current demand scenario remains strong but given the
uncertain global economy and low confidence on the business
environment, clients are unwilling to commit long term spends.
The strong traction of discretionary spend (started early CY10 and
showed excellent growth in H1 FY11) continues to be there. Deals
have become more integrated and transformational in nature with
couple of services bundled together. With large deals (TCV in the
range of US$1bn) now being broken into smaller portions, large
Indian IT players are increasingly able to match the requirements,
bid and win the deals thereby improving their wallet share in client
IT spends.
Modest increase in CY11 client budgets; flavour of spends
moving towards discretionary
While a full clarity on the CY11 budgets is elusive till the time we
write this, the fears of a negative budget surprise are fast fading.
Our interactions with the vendors suggest that though a strong uptick in budgets is a long shot, there being a negative surprise is
equally remote. The budgets are expected to be flat to marginally
positive (1-3%). Our conversation indicate that overall the nature
of spending is expected to be more discretionary which is expected
to be financed out of the cost savings on the ‘keep the lights on’
spend. We expect the momentum created due to the demand spurt
in last couple of quarters to moderate with pent-up demand being
largely addressed.
Pricing environment continues to improve; client-specific
increases on the cards
Pricing for Tier-1 companies has remained stable on like to like
basis with recent rate improvements being mainly driven by change
in the business mix on the back of increased discretionary spend.
Our conversation with the managements suggests clients’
increased receptiveness towards pricing re-negotiations. The
reversal in COLA adjustment & rate card discounts are harbinger
of strengthening pricing power going ahead, in our view. While
across the board pricing increases are distant, rate increases in
pockets (clients/ services) and discount reversals are realizable
come FY12.
Structural immunity to the MNC threat
Large MNC layers like IBM, Accenture, Cap Gemini have created
a substantial offshore presence in India with the scale of some
comparable to Indian vendors (India head-count of IBM is more
than 1lac now). From our conversations with Indian players and
channel checks, we understand that barring the high-end
consulting deals and niches in service lines (where MNCs have
strong competitive advantage), Indian players are competing
successfully and gaining wallet share in restructured deals. For
such deals up to US$300mn in size, Indian players have similar
capabilities as MNC players and thus have higher chances of
winning the deal considering the higher pricing (blended 10-15%
higher) of MNCs. Also poor linkages between the onsite and
offshore teams act against the MNC vendors sometimes.
Subsequently, we believe that structurally there is a negative case
for MNCs to compete successfully without hurting their revenues/
margins.
Margins expected to be in narrow range; forex is a key
over-hang
Employee utilization of Tier-1 players is expected to come-off with
increased hiring driven by the need to build a reasonable bench to
deliver on growth. Robust hiring leading to strong wage hike next
year has become a credible possibility. On the other hand, improving
pricing power, improving business mix, offshore ramp-ups and
broadening employee pyramid would provide considerable support
to the margin. For the big Indian vendors, we expect margin to
move in a narrow range.
Retain positive stance on the sector; Prefer Infosys and
TCS
Based on confidence increasing conversations and improve macro
environment, we retain positive stance on the Indian IT services
sector. However, we are distinctly biased towards the Tier-1 vendors
(TCS, Infosys and Wipro) and expect them to deliver robust dollar
revenue CAGR of 25-30% over FY11-13 on stable margins (forex
only being a key risk). The mid-cap IT services companies are
likely to take some more time to fully participate in the recovery.
Despite the recent rally, we believe Tier-1 stocks provide value as
valuation has shifted to FY13. Amongst the Top 3, we are relatively
more bullish on Infosys and TCS.
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