Tier 1 IT Services — Humpty Dumpty sat on a wall…:: Ambit research

Please Share:: India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��

THEMATIC

IT-Tier 1 IT Services — Humpty Dumpty sat on a wall…

Tier 1 Indian IT firms have outperformed the Sensex by 14% over the last twelve months and are trading at ~20x FY12 P/E. Such share prices imply long term revenue growth rates >20% over FY11-16 and sustained margin performance. Our reverse DCF analysis indicates that this will be tough to achieve given: a) the increasingly competitive stance taken by western competitors, b) the changing sources of competitive advantage, and c) structural wage inflation in India. Whilst the Tier 1 IT vendors are likely to show strong ongoing momentum in CY11, this is already priced into current valuations whilst the likely (and painful) evolution of the current business model is at presently being ignored by the stockmarket.

Tier 1 IT firms have clearly seen a cyclical recovery in BFSI led spending. Recent positive newsflow about the US economy and tech spending has also helped. However, with sector up 35% over the last 12 months and trading at 16-22x FY12 earnings most of the positives seem priced in. Indeed, our estimates suggest that the market is pricing in 20%+ 10 year revenue CAGR and maintenance of current EBITDA margins over the next 10 years. With the top three firms clocking over $5bn in revenues and with margins at a three year high, do the Indian IT firms have long term competitive advantages to justify their current valuations?

• Short term drivers remain strong: The primary short term growth driver for the industry has been the recovery in BFSI spending, post merger integration work and pent up demand in other verticals due to frozen budgets during the downturn. We expect most of these drivers to remain strong over the next 6-9 months, with Infosys, TCS and HCLT best placed to benefit.
• Structural shift in spending from ADM to EAS: There is an underlying structural shift in spending away from Application Development (AD) towards system integration and consulting around Enterprise Application Software (EAS eg. BI, CRM, ERP software). This change is likely to emphasize a different set of selling points to those in ADM (primarily consulting skills, domain knowledge and ability to manage complex transformational projects - skills that several Indian IT firms lack). We find HCL Technologies and TCS best placed in such an environment.
• Margin sustainability: The Indian IT industry faces a structural challenge from rising wage inflation (likely to be in double digits for the foreseeable future) and from rising investment in Sales & Marketing (compared to global peers, the Indian titans have underinvested in this area). We expect EBITDA margins to remain under pressure as the primary margin levers of offshorability and pyramid flattening have now been fully exploited. Indian firms with a greater proportion of fixed price contracts and the ability to manage higher utilization are better placed to face these structural problems. TCS and Wipro stand out as the best placed.

The recent strong sequential results of the top Indian IT firms have masked the structural commoditisation of their bread & butter business - ADM. Once the one-off benefits of a recovery wear off over the next few quarters, Indian firms will face an existential challenge to maintain growth and competitive advantage over a longer period (by either moving up the value chain or choosing to chase only scale). We find only TCS (HOLD) and HCL Technologies (BUY) choosing one of the two strategies.Infosy (SELL) and Wipro (SELL) have a more ambiguous positioning. HCL Technologies is our top pick due to its fortuitous position with both short term and long term growth drivers and reasonable valuations to boot.