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INDUSTRY OUTLOOK Ï
ƒ New drivers: raised BNPP US/ Europe GDP ests, long-term deals return
ƒ Cues from FY03: extended rebound likely, non-BFSI may steer next leg
ƒ Strong campus hiring points to improved pipelines, stable margins
ƒ Stocks far from overvalued zone. BUY INFO, WPRO, TCS, PSYS, RLTA
Another strong year ahead
2010 drivers are further enhanced as we enter a new year
New positive indicators have emerged that could drive Indian IT stocks to another
year of healthy returns. Our economists have raised their GDP forecasts for the
US and the Eurozone, and see US corporate spending as an upside risk. While
our checks continue to suggest strong near-term demand visibility for Indian IT
companies, recent deal wins point to short-term project driven growth paving the
way for more sustainable growth from longer-term projects. Over the next few
years, we would also keenly watch Indian IT’s progress with newer clientele
(government and SMEs) and delivery models (platform and cloud offerings).
Lessons from the previous rebound
Our analysis of the previous recovery in 2002-03 suggests that : 1) The rebound
lasted much longer than was anticipated. For example, Infosys maintained the
average revenue growth of the first six quarters of the recovery in the next four,
which suggests that a prolonged rebound now is not an aggressive assumption to
make. 2) Just as with the current recovery, early-adopter financial services clients
led the previous one in 2002, but steadied to a lower-than-average growth
eventually. On the other hand, telecom, manufacturing and other verticals picked
up. For this reason, we believe Infosys and Wipro (with their higher non-financials
exposure) could at least match TCS’s growth going forward. It also explains our
continued positive stance on Wipro, despite its near-term supply-side troubles.
The real margin game is in campus graduate hiring
We believe Street worries of margin pressures due to rising wages are overdone.
Several colleges have reported record hiring from large IT companies this year,
which suggests lower average salary costs ahead and therefore reduced margin
risks. Despite the popular focus on factors such as utilization, we believe campus
hiring has historically been the biggest margin lever for Indian IT players.
Raise ests further above Street, like large-caps, niche players
We raise our FY12-13 EPS estimates by 2-7% for our large-cap coverage (our
estimates are now 4-12% higher than consensus for BUY-rated stocks) on a
weaker USD/INR and improved demand. We retain BUY on Infosys, Wipro and
TCS, and HOLD on HCL Tech (while awaiting a margin recovery). Among the
mid-caps, we continue to prefer niche players, Persistent Systems and Rolta
India. To address investor concerns of rising valuations, we revisted our historical
DCF models and found that large-cap stocks are trading close to their base case
fair values, well below the bull values which have historically pointed to
overvaluation. Risks: unexpected macro weakness, adverse currency fluctuations.
2010 drivers are further enhanced as we enter a new year
Large cap Indian IT stocks (TCS, Infosys, Wipro and HCL Tech) are trading at their 10-
year highs having outperformed the BSE Sensex by 3-38% in 2010 (the BSE Sensex
returned 17% in 2010).
We believe the main themes that drove stock returns in 2010 (discussed in the next
section) still remain. More significantly, as we start 2011, further positive indicators
continue to emerge. Firstly, our economists have raised their GDP forecasts for
developed economies (Exhibit 2, “Global Outlook”, dated December 2010), and see US
corporate spending as a positive risk to their estimates. Secondly, our industry checks
and meetings with companies continue to suggest strong near-term demand visibility for
Indian IT services companies. Also, what has so far appeared to be short-term project
driven growth seems to paving the way for more sustainable revenue from longer-term
projects as clients become more confident of the macroeconomic environment. Thirdly,
companies are making record graduate-level hiring which points not only to improved
order pipelines, but also to reduced risk to margins as average salary costs could likely
come down. Finally, the USD/INR has not appreciated as much as we had modelled,
and therefore provides an upside to our estimates.
We therefore raise our FY12-13 EPS estimates by 2-7%, and to further above
consensus forecasts (our FY12-13 EPS estimates are now 4-12% higher for our BUYrated stocks) across our large-cap coverage on a combination of a weaker USD/INR
and demand improvement (specifically for Infosys and HCL Tech, where we believe our
previous forecasts may have been conservative).
We retain our BUY ratings on Infosys, Wipro and TCS, and HOLD on HCL Tech (as we
await a margin recovery). Among the mid-cap companies we follow, we continue to
prefer niche players, Persistent Systems (play on pervasive computing) and Rolta India
(likely beneficiary of increased Indian defence spending).
So what’s new in 2011?
Macro data have improved in developed economies
Our global economics team believes that that recent improvement in US economic data
suggests that downside risks in the US have diminished considerably (according to
BNP economists, the chances of a double dip recession are now only 10% versus the
previous 25%), which has led them to raise their GDP forecasts. Our team now expects
the US and Eurozone GDP to grow 2.1/1.3% and 2.8/1.7% in CY11/12 versus 1.6/1.1%
and 2.6/1.4% previously.
All that cash .. . will be put to use at some stage
As previously highlighted in our research (“Of disruptions and avalanches”, 12 March
2010; “The Big Picture Book”, 8 July 2010), data from our economics team suggest that
US corporate cash flow as a proportion of GDP is now at a new six-decade high.
However, this increased corporate cash flow has not yet translated into a proportionate
increase in tech investments, which have at best clawed back to the medium-term trend
line. Yet, tech capex is less volatile and has tended to lag cash flows historically, and
clients could have still been cautious on big-ticket spending so far - both of which
suggest there is enough in the story to stay positive. In fact, our economists see upside
risks to their GDP forecasts from firms putting their cash balances to work in
investments and hiring.
Long term projects are coming back
Indeed, our recent industry checks and management meetings have repeatedly pointed
to short-term projects driving the bulk of the growth so far and that long-term revenue
visibility has been lacking. In fact, a comparison of growth rates of Indian IT players
versus their global peers (who depend more on longer-term order books) show the
clear effect of short-term projects on growth.
Indian IT growth rates slowed ahead of their global peers before the macro slowdown in
2008, but also recovered much faster during the rebound in 2009 suggesting short-term
projects that may have been stopped as the downturn started may also have been the
first to come back.
Had this trend of short-term project-dependent growth continued, risks to our estimates
could have emerged in 2HCY11. However, recent deal announcements point to early
signs of larger deals returning (Exhibit 6). In fact, industry estimates suggest multi-year
outsourcing deals worth anywhere between USD25-40b are due for renewal this year,
which makes the bottom-up picture look exciting for Indian vendors.
More significantly, we believe the larger Indian players have also used the downturn to
improve their scale, skills and sales teams, and are now more likely to win a larger
share of longer-term projects than they have historically been able to win. We would
therefore not be surprised if managements talk of increased visibility as client budgets
are being finalized between January and March 2011.
We believe share gains should drive Indian IT industry growth over the next five years.
Our simulation suggests that an annual 50bp market share gain would lead to a 15%
revenue CAGR, while a 100bp gain would lead to a 23% CAGR for Indian IT services
companies
Lessons from the previous rebound
Since we are now about six quarters into the demand recovery for Indian players, we
looked at the previous recovery in 2002-03 to better understand what lies ahead for the
next four quarters. We use data from Infosys for our analysis given its availability and
consistency (TCS was not listed in 2002, while Wipro has since changed its segment
reporting methodology). While there would always be some differences between the
two recoveries, we believe we can also draw some useful conclusions by examining
what took place in the last one:
1 Recoveries last longer than is initially anticipated: The previous rebound lasted
longer than was anticipated. Infosys’ USD revenue expanded at a 10% q-q
average rate in the first six quarters, and then continued at a 10% q-q average rate
over the next four quarters. In the current rebound, its revenue has expanded
about 5% average q-q in the first six quarters (lower than the previous recovery
given its larger revenue base), and our current estimates call for another roughly 5-
6% average q-q expansion over the next four quarters. Therefore, on the face of it,
we believe our estimates do not look aggressive.
2 Early-adopter financials lead, but other verticals take over eventually: While
the financial services vertical drove the recovery in 2002, it steadied to a solid
pace, but lower-than-company average growth in the next four quarters. On the
other hand, growth from telecom, manufacturing and others picked up. We believe
it could be similar in this recovery. Financials have led above-average growth for
the first six quarters of this rebound as well, but initial indications are that the
manufacturing (semiconductors, etc), retail and telecom (wireless more than
wireline) verticals could drive the next leg of growth, while financials could steady
into a slower, but solid growth. The main difference in the two recoveries, of
course, is that the telecom vertical has been a laggard in the recent recovery, but
we believe that could change in FY12.
Therefore while our revenue growth estimate for FY11 is the highest for TCS (given its
high financial services exposure), we expect Infosys and Wipro to at least match its
growth rate in FY12. It also explains our continued positive stance on Wipro (which has
significantly lower financial services exposure than peers) despite its near-term supplyside troubles.
The real margin game is in fresher hiring
Recent Street worries have centered on risks to margins of Indian IT companies
because of rising industry wages. However, data we gathered from the media suggest
that the larger players have been extremely actively recruiting on engineering college
campuses this year, with record hiring reported from several campuses. This leads us
to believe that the “recruitment muscle” of the larger players will allow them to manage
their margins as will their scale benefits.
While there is often too much focus on near-term factors such as utilization and onsiteoffshore mix to determine margin levers, we believe fresher (campus graduate) hiring
has historically been the single-biggest margin lever for Indian IT companies. Taking
Infosys as an example (the company has historically been the best at managing
margins, while TCS and Wipro are now catching up in their ability to manage margins),
we note that even though it has historically given 10-15% offshore and 3-5% onsite
annual wage hikes to its employees (except in FY10 which coincided with the global
downturn), the company has largely maintained its cost of services as a proportion of
revenue (and its EBIT margins) without signficantly changing near-term levers such as
utilization and onsite-offshore revenue mix.
The first near-term risk
The first near-term risk to stocks could emerge in April if bellwether Infosys’s initial
FY12 guidance proves overly conservative relative to Street estimates. As noted earlier,
companies have complained of lack of long-term visibility, which in turn could have a
bearing on Infosys’s guidance. Some gap between Infosys’s intial guidance and Street
estimates is to be expected given the company has eventually beaten its initial annual
EPS guidance by 9.4% since FY02. Nonetheless, Infosys’s annual stock returns have
been a function of the “guidance gap” and too wide an initial gap may not be comforting
for investors, in our view.
Going beyond the traditional strong holds
The longer-term picture for Indian IT services companies is less clear than that for the
next one to two years, and our concerns of maturing service lines and top client
accounts, and the sheer limitations of headcount-based models (especially given large
players have over 100,00 employees each) still remain. In the traditional hunting
grounds for Indian IT players (financials, industrials, telecom, etc), beyond the top few
accounts, account sizes tend to rapidly shrink making them unattractive for IT services
vendors. Therefore annual growth rates could eventually moderate from the current 25-
30% levels to below 20% over the medium-term.
But as we noted in our previous reports (“The Big Picture Book”, 8 July 2010), those
concerns are being alleviated somewhat as companies compete for newer clientele
(such as in healthcare, government and SMEs) and offer newer services and delivery
models (infrastructure services, platform-based models and in due course, cloud
computing).
1 We believe the government sector (US and UK combined) could be a likely
USD100b multi-year opportunity and is becoming a focus area for Indian IT
companies. Infosys and Wipro have made top level hires to tap into the
opportunity, while TCS, HCL Tech and Patni are engaging with lobbying firms to
reach out to lawmakers in the US. Indian IT companies have also set up
delivery/development centres in the US and the UK and have stepped up hiring
from local communities.
2 New engagement models (pricing, platforms) could generate 15-30% of revenue
from currently less than 10% over the next 2-3 years.
3 The small & medium enterprise (SME) market remains relatively untapped and is
currently a focus area for Indian players. TCS and Wipro are at various stages of
testing services in the domestic market for small & medium enterprises (SME)
before attempting global launches. As per NASSCOM data, SMEs account for over
30% of the domestic and global IT services markets.
Cloud computing could provide opportunities in the long-term
We believe that cloud computing could lead to a paradigm shift in the way enterprises
spend on IT in the long-term. Even if it is a little early to look at the topic, we believe the
concept of cloud computing is here to stay and investors will likely hear much more on it
with each passing quarter. In our last report on cloud computing (“Cloud computing
conundrums”, dated 5 November 2010), we tried to sort through the hype and present
an on-the-ground look at how Indian players (and other Asian players) are responding
to this shift. We also included our in-depth interviews with the CTOs of Infosys, TCS
and Wipro in the report.
Broadly speaking, we see cloud computing as an amalgamation of multiple mini-
technology shifts and in the near to medium-term, we believe there could be many
different "clouds" - that will come in different sizes, shapes and locations - which will
lead to multiple investment opportunities.
1 We believe there could be large opportunities for Indian players as system
integrators and IP providers, especially in the private cloud area and we found that
all of them are taking their first steps to evolve their service offerings to meet new
customer requirements.
2 Large Indian vendors (Infosys, TCS, Wipro) are winning pilot orders and clients are
starting to show the mind set change needed to make the shift to cloud computing.
3 Indian companies have historically not been technology innovators, but rather have
been effective at monetizing new technologies (for eg: ERP) largely because they
are technology agnostic. We think therefore that cloud computing could present
more of an opportunity than a threat to the Indian IT companies.
Are Indian IT stocks getting expensive?
After the 3-38% outperformance of large-cap Indian IT stocks versus the BSE Sensex
in 2010, several investors seem to be voicing their concerns on stretching valuations.
To address these concerns, we revisted our historical DCF models that compare “what
was” vs “what should have been” and in our view, are useful visual aids to identify
buy/sell opportunities for the long-term.
As part of this exercise, we back-calculated the historical DCF fair values of stocks
using reported numbers. In other words, these are the prices a stock should have
traded at if investors had perfect information about future earnings. At current prices,
stocks are trading at close to their base case fair values, well below the bull case prices
which have historically pointed to overvaluation.
For this reason, we believe that stocks are far from overvalued and that in the wake of
20%+ EPS CAGR that we forecast over FY11-13, they could in fact trade above our
base case fair values. As a result, our new TPs are set in between our base and bull
case values.
Our new TPs for Infosys, TCS, Wipro and HCL Tech of INR4,000, 1,300, 590 and 500
imply FY13 P/E multiples of 13-21x versus the 15-22x that they currently trade on an
FY12 basis.
The key risks to our call remain an unexpected adverse turn in the macro economic
situation, unavailability of quality talent, and sharp USD/INR appreciation.
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