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Information Technology: Sector Outlook
We remain bullish on the Indian IT sector for FY12. A capex led US recovery and strength in
Banking and Financial services vertical underpin our bullish thesis on the sector. We expect
Tier 1 players to deliver another year of solid top-line performance and are building in 27%
US$ revenue growth.
Our positive view on the sector ties in with our regional strategy view of favouring Tech stocks
that are leveraged to US recovery cycle. Recent US economic data points and quarterly
results from leading tech firms support our positive investment view.
US capex spend at historical lows. Our US economics team expects a capital
expenditure “catch-up” to provide a solid tailwind for US GDP growth in 2012. Strong US
corporate revenues and earnings, increasingly available low-cost capital, depreciated
capital bases and low capex/sales ratios will likely lead to increased spends on IT (Figure
below). US firms also have increasingly large cash balances on their balance sheets – for
example, US non-financial firms’ money market mutual fund holdings more doubled from
US$300bn in 1Q03 to more than US$700bn in 4Q08.
ISM Manufacturing Index is at its highest since May. The ISM Manufacturing Index, a
purchasing managers’ survey, is one of the key measures of business conditions in the US
economy. The index is based on responses from individuals within the economy who are
actually purchasing goods, thus it provides an extremely insightful view into where the
economy is heading. The index is designed so that measures above 50 indicate economic
expansion, while those below 50 signal contraction. The index came in at 56.9 in
November, which is its best level since May. For comparison, the 10-year average stands
at 51.2.
Oracle and Accenture results takeaways. Accenture and Oracle declared strong
quarterly results in December. Accenture delivered double-digit YoY growth for the first
time since 2008. Oracle reported 23% YoY growth in the new software license sales, which
bodes well for discretionary spend – supporting our Outperform rating on HCLT.
Sector Top Picks
Top Buy Recommendation/s
TCS (Outperform; TP: Rs1,200; Potential upside: 6%)
Infosys (Outperform; TP: Rs3,500; Potential upside: 8%)
See another 15% upside on top of the recent run. TCS and Infosys stocks have had
strong performance in 2010 (up 55% and 32% respectively). Our bull case scenario
analysis suggests 15%+ upside to stock prices from these levels. This analysis is based on
our channel checks that suggest FY12 would see increased client IT spend and business
momentum should continue. As a result, we see upside to our and street EPS estimates to
support another leg up in the stock prices.
FY12 pricing and margins – could surprise positively. We are currently building in 2–
4% YoY pricing improvement for large cap stocks in FY12. Two consecutive years of
strong demand environment should allow vendors to negotiate for higher prices. In
addition, our view on rupee appreciation (avg. of 42 vs USD) is conservative and stable FX
alone could potentially add 6% to our EPS.
Premium valuation multiples sustainable. Positive surprise on three fronts - volume
growth, pricing uptick and stable currency could result in 25%+ earnings growth in FY12
(vs. current est. of 18% growth) supporting premium valuation multiples in the 23-25x one
year forward PER band.
Key Near-Term Catalyst
Finalisation of CY11 budgets in Jan – Feb 2011.
Top Sell Recommendation
Mphasis (Underperform; TP: Rs510; Potential upside: -25%)
FY11 margins to be below target band. Management expects to spur growth in FY11 by
making additional investments in the direct sales channel and targeting new geographies.
We believe the company would have to sacrifice margins to pursue top-line opportunities.
Mphasis CEO agrees that FY11 margins for the company would be below its target range
of 20-22% (Macq: 20%). The current street estimate is 21.1% for EBIT margin, and we
expect consensus expectations to reset post the analyst meet.
Supply side pressures handicap margin levers. An improved demand outlook for the
sector has resulted in higher attrition, especially for Tier 2 players. Mphasis saw a 30%
attrition rate for its Apps, 25% for ITO and 70% for its BPO business on a last twelve
months (LTM) basis. This is higher than industry peers and, coupled with higher offshore
mix for the company, limits scope for manoeuvring margins.
Pricing renegotiations with HP to continue. Mphasis derives 72% of its revenues from
the parent company HP (61% stake). The services contract between the two comes up for
negotiation every six months and pricing uncertainty associated with same to continue.
Key Near-Term Catalyst
Pricing renegotiations from HP
Switch from Mphasis to HCLT
Rationale
We believe that muted earnings growth for Mphasis due to margin pressure and sharp
increase in tax rate would result in stock price underperformance in the next year. We like
HCLT for its strength in infra management and enterprise application services. We believe
that incumbency in the fastest-growing Infrastructure management space gives HCLT a
near-term advantage over MphasiS. As such,we recommend switching from Mphasis to
HCLT.
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