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IT services & software
Action
We expect FY12F to see strong but moderating revenue growth compared with
FY11F on the tailing off of one-offs, such as for M&A integration, pent-up spending,
vendor consolidation gains and base effects. Supply-side risks, limited operational
scope and increased taxation should moderate flow through of growth to earnings.
We remain NEUTRAL on the sector. HCL Tech is our top large-cap pick, while we
prefer Mphasis among the mid-caps. Among our NEUTRAL calls we prefer Infosys.
Catalysts
Surge in discretionary demand and rebid wins could provide upside to revenue.
Rupee appreciation and greater MNC offshoring remain downside risks.
Anchor themes
Aggressive MNC offshoring trends could blunt the competitive advantage of Indian
IT vendors, leading to a reduction in margin differentials and valuation premiums.
Moderation ahead
Demand upswing likely to moderate heading into CY11
We believe tier-1 companies will likely report strong growth of 27.6% on average
in FY11F, aided by a pickup in discretionary spending and a rebound in lagging
segments such as telecom and manufacturing. We believe such demand strength
is unlikely to continue in FY12F, however, as one-offs such as bank M&A projects,
vendor consolidation benefits and pent-up demand trail off within the next two
quarters. Pricing increases too are likely to be marginal and more a result of a
shift in revenue mix rather than billing rate increases. We look for 21.5% revenue
growth for tier-1 companies in FY12F. We see positive surprises likely in: 1)
Infosys − if discretionary spending improves significantly; and 2) HCL Tech − if the
company continues to gain market share from MNC vendors in deal re-bid
contracts on account of its infrastructure management services (IMS) strength.
Margin bias downwards on wage pressures and sales
investments
We expect FY12F to see elevated hiring levels, last seen during the previous
high growth years of FY07 and FY08, which could lead to double-digit wage
inflation and likely fresher wage inflation (last seen in FY08 at ~30-40%).
Increased sales investments to target large rebid deals, and limited utilisation
scope due to high attrition could further exert pressure on margins, in our view.
We think margins will have a downward bias in FY12F, which makes us cautious
on the sector. HCL Tech has the best operational scope among the tier-1
companies, in our view.
Upside limited by valuations and muted earnings growth
We expect limited upside to stocks as 1) we estimate valuations are at or higher
than five-year averages for most companies and 2) earnings growth is muted
relative to revenue growth over FY10-12F. YTD, most stocks under our coverage
have seen only single-digit consensus earnings upgrades (except for TCS).
HCL Tech and Mphasis are our top picks in the sector
HCL Tech is our top large-cap pick on its ability to compete with MNC players in
large deal rebids, best-in-class earnings growth and attractive valuations.
Mphasis is our top mid-cap pick on being a clear play on MNC offshoring and
upside from inorganic growth.
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