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Information Technology
New Bytes...Indian Tech beginning to discount them
In this report, we look at the technology cycles across key segments over the
last decade and examine leading indicators that could suggest the onset of a
new cycle. Additionally, we ascertain the revenue and growth expectations for
key clients and outsourcers spanning verticals relevant to Indian IT.
Our key findings are: (1) Tech spending should remain robust and improved US
corporate health could usher in a new tech cycle, if aided by the US economic
recovery. (2) CY10 saw a strong rebound in semiconductors and hardware driven
by a hardware refresh across the enterprise segment; software and services could
witness a pick-up in growth over the next two years. (3) The software segment
(mid-cycle play) is best positioned given modest expectations and the likelihood
of the highest earnings upgrades. (4) For Indian IT, the BFSI, manufacturing and
retail verticals are likely to report strong growth in outsourcing in CY11, while
companies with large telecom exposure could continue to lag peers.
Overall, we believe technology investors globally would find more value in
software/hardware names which have higher scope for earnings upgrades,
superior operating leverage and greater comfort on valuations. The Indian
technology space is now trading at a premium to global technology, and
valuations are already beginning to discount the new cycle.
Technology spending likely to remain strong: US corporate profits are at the
peak levels last seen in CY07; this should continue to drive technology spending.
US tech investment is currently at 4.1% of GDP and has crossed its 8-year
average of 3.7%. Further, there is an increased focus on operational efficiency
among corporates, which in our view could attract continued investment in
technology. We believe that drivers for tech spending must be supported by
greater confidence in the US recovery. Though the outlook for spends remains
stable, we are yet to see any sharp increase in IT budgets.
Software offers maximum leverage: From a cyclical perspective, hardware/
semiconductors tend to be an early play into the entire tech refresh cycle, while
software and services tend to be mid/late-cycle plays. The recovery in software,
though solid, has lagged behind the semi/hardware segment in CY10. In the present
context, should the tech cycle continue, we believe that the strong rebound in
semi/hardware in 2010 could prompt a rebound in the software segment. Further,
analyst expectations in key software names indicate a modest 5–8% growth, far
below the peaks of 2003–07, suggesting potential for upgrades. While we do
expect services to benefit from the tech cycle, we believe valuations in software/
hardware remain reasonable given the current earnings CAGR and likely upgrades.
Global tech valuations undemanding: Valuations across global technology names
remain reasonable, with most of them in line or below their 5-year average
multiples. We recommend that global tech investors look at software names to
play the tech cycle given possible earnings upgrades and higher comfort on
valuations. While we do expect services to benefit from the upcycle, we believe
that the valuation premium of the Indian IT services space has widened
significantly (Infosys at 58% premium to Accenture). Further, following the recent
round of earnings upgrades, Indian tech is now beginning to discount the new
technology upcycle. We are positive on Oracle Financial Services Software
(OFSS), which is the only large software play in India. As for large Indian IT
services names, we would turn more positive post a 10% correction.
Executive summary
Technology spending has seen a sharp rebound in 2010 with strong growth witnessed in
the hardware segment. Given the improving macro environment in the US, robust
corporate profits and high cash levels, US corporates are adequately positioned for
investment in technology upgrades, after significant underinvestment over the past two
years. Here, we conduct a study to determine how different segments in the tech supply
chain are positioned for the cycle and the upsides one can expect, particularly with
respect to Indian IT companies. We also examine the current outlook of other industry
verticals in the context of IT Services to ascertain growth visibility for the latter over the
next two years.
Decoding the tech supply chain
The tech supply chain can be broadly classified into four segments—semiconductors,
hardware, software and services. Of these, hardware, software and services are to some
extent directly exposed to the end demand for technology (corporate / consumer), while
the semiconductor segment directly feeds into hardware. From a cyclical perspective,
hardware/semiconductors tend to be an early play into the entire tech refresh cycle
while software and services tend to be mid/late-cycle plays.
In the present context, 2010 saw a strong tech spending rebound, driven by increased
hardware spends, which we believe could remain strong in CY11 as well. While this
does bode well for the services segment, we note that services growth lagged behind
other sectors for the first four years coming out of the tech bubble. As such, should the
tech cycle pick up, software could see a higher share of consensus upgrades over the
next two years, while the services sector could see meaningful upgrades only from CY12
onwards.
Considering the new refresh cycle, it is important to know how services fit into the entire
scheme of things. We note that the services segment is largely exposed to end demand
through three primary linkages: (1) Directly in the form of corporate IT budgets for apps
development/maintenance, business processes and handling of IT infrastructure;
(2) Through software in the form of package implementation (PI) and testing services;
and (3) Through hardware in the form of embedded software design and testing services.
While ADM is largely independent of the hardware and software, it is likely to gain
strength only towards the middle of the tech cycle, while PI and consulting could see
strength during the early stages of the cycle as well. Our current estimates for top tier
Indian IT companies point to 24%/18% growth in CY11/CY12.
Valuations
We also look at valuations across the tech space and find that Indian IT companies are
significantly more expensive than global tech players. Even within the services space,
Infosys’ premium over Accenture has widened significantly over the past few months to
58%. We believe tech investors globally would find more value in software names
which have higher scope for earnings upgrades, stronger operating leverage and better
comfort on valuations.
Right ingredients in place for a new tech cycle
In our view, US corporate health remains stable with expectations of a recovery in the
US economy, healthy corporate profits and strong cash balances with companies. While
there are initial indications of a new tech cycle, real triggers will emerge only once we
see more clarity on any rise in IT budgets from leading companies and a revival in the
US consumer sector, which has been a laggard so far.
Corporate profits to support spending
While there are still concerns over the macro environment, US corporate profits have
jumped sharply over the last 6–8 quarters, supporting investment in technology. US
corporate profits grew 28% YoY in Q3CY10 to reach 2007 levels, suggesting a
continued improvement in corporate health. US IT spending increased 12.2% YoY in
the third quarter driven by strong hardware spending (up 23% YoY). Further, the sharp
jump in corporate profits and underinvestment in 2008/09 are likely to result in record
technology spends in 2010. In the services space, the offshoring trend remains intact
with a sustained increase in market share for Indian IT in Q3CY10.
Growth across tech supply chain
2010 – A year of strong rebound
Technology spending has recovered sharply coming out of the recession, with US tech
spending expected to have grown more than 10% in 2010 after a 3% decline in 2009.
The growth was largely driven by increased spending in the enterprise segment where a
refresh cycle is kicking in. As seen from the chart below, the rebound in 2010 was led
by a sharp recovery in semiconductors followed by hardware, on the back of inventory
restocking and a pick-up in end demand. While services growth has been muted, we
highlight that Indian IT services players have seen 20%+ growth through the year, driven
by strong demand in the BFSI vertical (M&A and regulatory compliance–related work)
and a continued push towards offshoring as customers look to cut costs.
Technology trends for 2011
We believe that the tech spending environment is likely to remain sturdy in 2011 on the
back of improved corporate health, provided the macro environment remains stable. We
have broken down tech spends into four key areas: (1) Semiconductors, (2) Hardware,
(3) Software, and (4) Services. Thereafter, we have compiled 10-year historical growth
data and analyst expectations for the next two years for our selected sample set of key
companies. Based on consensus estimates, overall growth rates for CY11/CY12 would
likely be modest and with a pick-up in tech spending, there could be scope for possible
upgrades across the supply chain.
Our data reveals that 2010 saw a recovery in early-cycle plays, especially in the
semiconductor and hardware segment. While 2010 was clearly a year of strong
hardware refresh, we believe that if the tech cycle gains strength, software companies
stand to see the highest earnings upgrades in CY11/CY12. Both Oracle and SAP have
also seen a recovery in growth of new software sales throughout CY10. Growth
acceleration at the software stage should also directly help in the PI practice of Indian IT
players, besides being a precursor to further software and maintenance demand later
in the cycle.
In our view, services should also benefit from the coming tech cycle; however being a
later-cycle play, growth should pick up from CY12/CY13 onwards. Hence, even with a
heightened tech cycle, significant earnings upgrades here are likely to come in only
from CY12 onwards. Looking back at the recovery post the tech bubble, we note that
while services growth did rebound in 2003/04 off a low base, the segment had
underperformed the rest of the tech space for four years till 2007. From an Indian IT
standpoint, our current estimates for FY12/FY13 already stand at 24%/18%. As such,
should the tech cycle gain strength, there could be some upside to our estimates
for FY13.
Growth expectations across key verticals for Indian IT
We look at the revenue and growth expectations for key clients and outsourcers across
verticals in the context of Indian IT. Among the top-tier Indian companies, BFSI has been
the key driver of spends in 2010 and contributes ~40% of revenues. This is followed by
manufacturing which contributes 16% and telecom ~14–15%.
We note that coming out of the downturn, offshore players with higher exposure to the
BFSI, retail and healthcare segments have seen stronger growth than companies with
high telecom and manufacturing segments. Our analysis on the current outlook for these
sectors indicates that the BFSI, manufacturing, retail and healthcare segments should see
strong growth in outsourcing in CY11 as well, while companies with large telecom
exposure could continue to trail behind peers.
BFSI
Indian IT companies have seen strong growth in the BFSI vertical in CY10 with all the
leading players recording 25%+ YoY growth in the last quarter. Consensus estimates for
our sample set of 14 leading global BFSI companies indicate that they are likely to grow
by 2%/5% in CY11/CY12 after a flat CY10.
Telecom
The telecom vertical has witnessed a weaker rebound coming out of the recession and
companies with a larger telecom exposure have seen growth lagging their larger peers.
Our sample of 13 global telecom players indicates that telecom revenues have stagnated
over the past 2–3 years and consensus estimates for the same do not indicate any major
improvement in growth rates in CY11/CY12.
Manufacturing
Although our sample set of 13 manufacturing companies indicates that manufacturing
revenues are expected to grow by 10% in CY10 post a decline of 12% in CY09, the
manufacturing vertical for IT services has only recently started to gather pace. Both
Infosys and TCS have seen YoY growth improve in the September quarter. Consensus
estimates indicate that manufacturing companies should post a growth of 6%/7% in
CY11/CY12; we believe growth should return to the vertical over the next two years.
Retail
Our sample of 18 retail companies is expected to show 5% growth in revenues in CY10
following a 2% decline in CY09. Retail has been one of the fastest growing verticals for
Indian IT players, as global companies continue to increase outsourcing in order to
improve operational efficiencies. Consensus estimates indicate that growth rates in the
segment would remain at 5%/6% levels for CY11/CY12.
Other verticals
Among other verticals, healthcare is a fast growing segment for Indian IT companies
largely driven by regulation changes in the US healthcare space. The hi-tech vertical will
be another fast growing segment as technology companies benefit from improving tech
spends and higher testing outsourcing. Although healthcare companies are expected to see
a decent 8% revenue growth in CY10, growth rate expectations fall over the next two
years, possibly due to industry-specific issues such as key product patent expiries.
Offshoring continues to gain market share in services
Despite protectionist vibes in the US, Indian IT services continued to gain market share
through CY10, at the expense of global incumbents, as the trend towards offshoring
continued among US corporates. Based on consensus estimates for our sample of 15
large global IT service providers (except for the 4 Indian companies where we have used
our own estimates), we expect overall IT services revenue to grow 6.5%/6% in
CY11/CY12 compared to 24%/18% for Indian IT companies. We maintain our view that
Indian companies will continue to gain market share—consensus estimates indicate that
larger players would capture 13% market share by CY12, up from 8% in CY09.
Valuations across the technology space
Looking at Indian IT valuations in the context of the global technology space, we find
that Indian tech is already trading at a significant premium. Our conclusion is based on
the following: (1) Global tech (MSCI Global IT) is currently trading at 13x twelve-month
forward P/E compared to 25x for Infosys; (2) On P/B versus ROE, Indian IT companies
are far more expensive (Fig 36); and (3) Even within the services space, the premium of
Infosys to Accenture has widened to 58% versus the historical average of 40%.
We would advise global investors to play the tech cycle largely through
software/hardware in the early years of the cycle. We believe global tech stocks make
for better investments than Indian IT at present due to (1) the higher possibility of
consensus upgrades; (2) higher operating leverage in hardware and software companies,
leading to faster EPS growth; and (3) more comfort on valuations. For investors looking
to play the tech cycle in India, we would advise good quality second tier companies,
such as HCL Tech and strong product players like OFSS where valuations are cheaper.
As for large Indian IT services names, we would turn more positive post a 10%
correction.
Key risks to a tech cycle
Sluggishness in US economic recovery
While US corporate health has clearly been improving over the past year, concerns
linger over the revival in the consumer space. Retail sales have picked up, but they are
still below pre-recession levels. Unemployment rates remain high and could limit
consumer electronic spending. This in turn could hamper the tech cycle, in our view.
Corporate IT budgets remaining flat
In order to enable the start of a new tech cycle, we believe corporates would have to
raise their IT budgets in order to meet the higher spending requirements for hardware
and software refreshes. If IT budgets remain at current levels, we would at best see a
weaker-than-expected tech cycle.
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