Cognizant 4Q: Implications for Indian IT Services:: Citi Research

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Indian IT Services
Cognizant 4Q: Implications for Indian IT Services
 CTSH continues to outperform peers — CTSH (CTSH.O; US$75.40; 1M),
covered by our US IT Services analyst Ashwin Shirvaikar, reported a strong Q4
with revenue growth of 7.7% QoQ ($1.31b). The constant currency growth at
~7.2% qoq is again ahead of peers (TCS: 5.8%, Infosys (INFY): 4.7% , Wipro:
4.1%, HCLT: 6.5%).

 Guidance largely in line at ~26% growth yoy — CTSH has guided to CY11
revenue growth of “at least” 26% yoy ($5.79b) – largely in line with expectations. It
implies CQGR of ~4% qoq over the next four quarters. The 1Q guidance of ~3.8%
qoq looks a tad weak but not too different from peers – Infosys had guided 1-2%
qoq and Wipro to 3-5% qoq.
 Comments from the call — (1) Broad-based growth across verticals, geographies
and service lines – application development grew ~7% qoq; Europe was up ~7% in
constant currency terms. (2) Financial services grew ~6.6% qoq;
Retail/Mfg/Logistics grew ~5.6% qoq. (3) Headcount addition of ~8,300 staff taking
the total to ~104,000. (4) Attrition at ~16% annualized – down qoq. (5) Pricing was
up 1.5% onsite and ~2% offshore qoq.
 Demand environment buoyant — CTSH’s good performance highlights a
buoyant demand environment for the industry. Management indicated that
demand was good but CY10 benefited meaningfully from pent-up demand, M&Arelated
spending and some acquisitions as well. The guidance builds in some
moderation in discretionary spend in 2HCY11. Pricing commentary was also
positive.
 What’s the likely guidance to be from INFY? — Given CTSH has already
guided, India investors’ attention is likely to move towards INFY’s FY12 guidance
(INFY.BO; Rs3,089.05; 2L). Assuming ~4% qoq growth in 4QFY11 (guidance of 1-
2% qoq) and subsequent assumption of ~3-4% qoq growth over four quarters of
FY12, INFY could guide to ~17-20% growth. Given that expectations are running
at ~25% growth already, it is unlikely to surprise the street positively (at current
valuations).
 Neutral on Indian IT Services — Business momentum is strong in the near term;
however, expectations already appear to price in part of the strength. Margin
pressures due to wages and attrition challenges could limit the benefit of higher
revenues flowing to EPS. We think that valuations at ~17-22x FY12E EPS for the
larger players limit meaningful upsides – we maintain Neutral.


Cognizant Technology Solutions Corp
(CTSH.O; US$75.40; 1M)
Valuation
Our $85 target price is based on our price-to-earnings (P/E) valuation model
plus the ~$6 of net cash and investments per share on the company's balance
sheet. Our P/E-based model yields an implied $79 (rounded) valuation based
on our 28x-29x target multiple range applied to our 2011 GAAP EPS estimate
of $2.76. CTSH recently traded at a cash adjusted 2010 P/E of slightly over 28x
based on our 2010 estimate $2.36, so we believe a 28x-29x 2011 multiple is
appropriate. As further support, CTSH should grow pre-tax income by an
average of 28% over the next two years, so a multiple in line with growth rate is
a reasonable in our opinion. We utilized pre-tax income growth when analyzing
our target multiple given the uncertainty around Indian corporate tax rates
beyond 2010.
Risks
We rate Cognizant Technology Solutions Medium Risk based on the
expectation for continued growth at a faster clip than the rest of the industry
and the stock's dependence on the Indian stock market (because all its pureplay
comps trade there).
Risks to the achievement of our target price include the following:
1. Normal IT services vendor risks such as timing and magnitude of budgets;
Contract ramps; Pricing pressure are par for the course.
2. Normal offshore services risks including exchange rate volatility; the threat of
political backlash against offshore outsourcing; wage inflation in India; supplyside
constraints, including visa limits and infrastructure development in India
should be considered.
3. Senior management’s compensation is heavily impacted by stock option
grants. Based on the recent performance of the stock, senior management has
and may exercise significant amounts of options.
4. Though Cognizant does not trade on the Indian market, all of its
comparables do, and the company does respond to moves in the Indian
market, both up and down.


Infosys Technologies
(INFY.BO; Rs3,089.05; 2L)
Valuation
Our Rs3,220 target price for Infosys is based on 22x Mar' 2E EPS. This is close
to the higher end of the last 3-year trading band of 10-24x 12-month forward
earnings and factors in marginal deceleration in growth. Our estimates continue
to assume a certain PE premium to the market; this is justified, in our view,
given the strong FCF and ROIC for Infosys vs. the overall market. We believe
PE remains the most appropriate valuation measure given Infosys' profitability
record and higher earnings visibility.
Risks
We rate Infosys Low Risk which is inline with our quantitative risk-rating
system, which tracks 260-day historical share price volatility. Key downside
risks to our target price include: (1) any significant appreciation of the rupee
against the USD/EUR/GBP; (2) pressure on billing rates (as the company
continues to enjoy a premium in its billing rates); and (3) a prolonged slowdown
in the US economy. Key upside risks that could cause shares to exceed our
target price include: (1) a sharp recovery in the US/Global economy; and (2)
any significant depreciation of the rupee against the USD/EUR/GBP.