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India: Technology: IT Services
Equity Research
Improving risk-reward for Indian IT; reiterate Buy on HCLT, INFY
Market weakness on domestic worries offers entry points in IT
Recent macro-economic concerns risks like current account deficit, inflation
have led to 12% correction of the broader markets YTD. Though the Indian
IT sector has relatively outperformed, it has declined by 6% during the
same period, despite limited exposure to these macro risks. We believe
this has improved the risk-reward for large cap IT stocks and reiterate our
preference for large-cap IT stocks (see our Jan 12, 2011 note,"2011:
Revenue momentum accelerates; bias towards large-caps"). We note largecaps
are trading at 18X on FY12E P/E, inline with their 6-year historical avg.
Positive on global tech spending; Indian vendors continue to gain
We continue to remain positive on large-cap Indian IT firms for 2011. We
expect 25% revenue growth in FY12E for large caps, with incremental
revenues of US$11.5bn over next two years based on: (1) our Economists’ US
GDP forecasts (3.4%/3.8% in 2011/12); (2) global tech spending forecast of 6%
for 2011; (3) Ongoing investment in the BFSI vertical; (4) US$ appreciation.
Best stock ideas: Buy Infosys and HCL Tech, prefer large caps
We prefer Infosys and HCL Tech as our best ideas with 23% upside. We
expect 22% revenue CAGR, 280 bp expansion in EBIT margin by FY13, and
clean financials to lead HCL to deliver EPS CAGR of 27% over FY10-FY13E.
On INFY, we expect industry-leading revenue/earnings growth (28%/30% in
FY12E) on the back of a robust revenue outlook and stable margins. INFY is
trading at 19.3X on FY12E P/E, at a 9% discount to TCS (only 2nd time
historically) and 8% discount to its own 7-year historical average of 21X.
Currency could pose upside risk to valuations by 5%-6%
Currency has been highlighted as the single largest risk for 2011 by the
companies’ managements. We use a rate of Rs45/US$ for FY12E, below GS
ECS’ forecast of Rs47 to narrow potential FX volatility. At Rs47.0, Director’s
Cut valuation implies additional +5% to +6% variance from current levels.
Recent performance continues to suggest strong momentum
Revenue growth remained strong in 3QFY11 (3.1% qoq) despite being a
seasonally weak quarter. It was on the back of 3.9% growth in volume. We
believe 4QFY11 will be stronger at 7.7% qoq revenue growth due to strong
volumes, depreciating INR and easier comparisons. EU’s revenue growth
remained higher than US for 2nd quarter in a row, allaying concerns over EU.
Revenue momentum continues; Buy Infosys and HCL Tech
Revenue growth momentum continues on volumes; headcount additions positive
Revenue growth for the sector continues to remain strong over the last 4-5 quarters. The
growth has primarily been led by volumes as pricing has remained flat to down for the
companies over the past two years. We believe that 4QFY11 will be a stronger quarter with
7.7% qoq revenue growth on account of strong volumes, depreciating INR and easier
comparisons.
On the hiring front, the top 5 companies in the industry (including Cognizant Technology
Solutions (CTSH)) have been hiring about 25,000 billable employees every quarter for the
last five quarters. This accounts for 26% of the current employee base and a 35% increase
in the employee base as of 2QFY10. We believe such strong employee additions not only
contributed to strong revenue growth but are also a leading indicator of a robust pipeline
for these companies
Europe registers strong bounce back; BFSI/Retail may be the next growth drivers
After a weak 1H2010 due to concerns over the EU’s economy and significant depreciation
of the Euro/GBP, Europe has bounced back strongly as these concerns have eased. In fact,
in the last two quarters, India IT revenues from the EU has outperformed the US in terms of
revenue growth thereby allaying pipeline concerns, as was reiterated in our report dated
June 29, 2010,”Current EU concerns manageable; maintain positive M-T outlook”. In terms
of verticals, BFSI remains the strongest growing vertical. As M&A integration work tapers
off, we expect increased regulatory and compliance spending to drive IT spending in this
vertical. Retail has picked up strongly over the last two quarters and may be the next
growth driver, in our view
Margins stabilizing as attrition eases and wage hike impacts are behind us
Operating (EBIT) margins for the sector remained stable at 23% in 3QFY11 (vs. 22.9% in
2QFY11). As attrition showed signs of easing for most of the companies in the sector and
we believe wage hike impacts have been largely absorbed, we expect margins to stabilize
over the next year. However, we expect the next cycle of wage hikes along with increased
visa fee cost to impact sector margins in 1QFY12 marginally
HCL Tech and Infosys have the highest operating leverage from utilization
After adding 60,000 employees over the last two quarters, the top 5 companies’ utilization
levels have dropped to 73.1% (-150 bp qoq). At the end of Dec 2010, TCS was the highest
with 77.1%. We believe HCL Tech (at 70.1%) and Infosys (at 72.7%) have enough room to
expand their utilization levels and thereby supporting their EBIT margins over FY12E.
We expect HCL to expand its EBIT margin by 280 bp over the next six quarters and remain
stable by FY13, primarily due to: (1) normalization of attrition and spreading out of high
wages; (2) recovery in BPO business; (3) stabilization of SG&A as deal flow peaked out in
2QFY11; (4) as project ramp-ups get completed, movement towards offshore mix should
increase, resulting in better margins; (5) scale benefits and operational levers, like
utilization, could impact margin positively. We value INFY and HCLT on 12-month
Director’s Cut methodology. Downside risks for INFY and HCLT: currency appreciation,
slowdown in global tech spending.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India: Technology: IT Services
Equity Research
Improving risk-reward for Indian IT; reiterate Buy on HCLT, INFY
Market weakness on domestic worries offers entry points in IT
Recent macro-economic concerns risks like current account deficit, inflation
have led to 12% correction of the broader markets YTD. Though the Indian
IT sector has relatively outperformed, it has declined by 6% during the
same period, despite limited exposure to these macro risks. We believe
this has improved the risk-reward for large cap IT stocks and reiterate our
preference for large-cap IT stocks (see our Jan 12, 2011 note,"2011:
Revenue momentum accelerates; bias towards large-caps"). We note largecaps
are trading at 18X on FY12E P/E, inline with their 6-year historical avg.
Positive on global tech spending; Indian vendors continue to gain
We continue to remain positive on large-cap Indian IT firms for 2011. We
expect 25% revenue growth in FY12E for large caps, with incremental
revenues of US$11.5bn over next two years based on: (1) our Economists’ US
GDP forecasts (3.4%/3.8% in 2011/12); (2) global tech spending forecast of 6%
for 2011; (3) Ongoing investment in the BFSI vertical; (4) US$ appreciation.
Best stock ideas: Buy Infosys and HCL Tech, prefer large caps
We prefer Infosys and HCL Tech as our best ideas with 23% upside. We
expect 22% revenue CAGR, 280 bp expansion in EBIT margin by FY13, and
clean financials to lead HCL to deliver EPS CAGR of 27% over FY10-FY13E.
On INFY, we expect industry-leading revenue/earnings growth (28%/30% in
FY12E) on the back of a robust revenue outlook and stable margins. INFY is
trading at 19.3X on FY12E P/E, at a 9% discount to TCS (only 2nd time
historically) and 8% discount to its own 7-year historical average of 21X.
Currency could pose upside risk to valuations by 5%-6%
Currency has been highlighted as the single largest risk for 2011 by the
companies’ managements. We use a rate of Rs45/US$ for FY12E, below GS
ECS’ forecast of Rs47 to narrow potential FX volatility. At Rs47.0, Director’s
Cut valuation implies additional +5% to +6% variance from current levels.
Recent performance continues to suggest strong momentum
Revenue growth remained strong in 3QFY11 (3.1% qoq) despite being a
seasonally weak quarter. It was on the back of 3.9% growth in volume. We
believe 4QFY11 will be stronger at 7.7% qoq revenue growth due to strong
volumes, depreciating INR and easier comparisons. EU’s revenue growth
remained higher than US for 2nd quarter in a row, allaying concerns over EU.
Revenue momentum continues; Buy Infosys and HCL Tech
Revenue growth momentum continues on volumes; headcount additions positive
Revenue growth for the sector continues to remain strong over the last 4-5 quarters. The
growth has primarily been led by volumes as pricing has remained flat to down for the
companies over the past two years. We believe that 4QFY11 will be a stronger quarter with
7.7% qoq revenue growth on account of strong volumes, depreciating INR and easier
comparisons.
On the hiring front, the top 5 companies in the industry (including Cognizant Technology
Solutions (CTSH)) have been hiring about 25,000 billable employees every quarter for the
last five quarters. This accounts for 26% of the current employee base and a 35% increase
in the employee base as of 2QFY10. We believe such strong employee additions not only
contributed to strong revenue growth but are also a leading indicator of a robust pipeline
for these companies
Europe registers strong bounce back; BFSI/Retail may be the next growth drivers
After a weak 1H2010 due to concerns over the EU’s economy and significant depreciation
of the Euro/GBP, Europe has bounced back strongly as these concerns have eased. In fact,
in the last two quarters, India IT revenues from the EU has outperformed the US in terms of
revenue growth thereby allaying pipeline concerns, as was reiterated in our report dated
June 29, 2010,”Current EU concerns manageable; maintain positive M-T outlook”. In terms
of verticals, BFSI remains the strongest growing vertical. As M&A integration work tapers
off, we expect increased regulatory and compliance spending to drive IT spending in this
vertical. Retail has picked up strongly over the last two quarters and may be the next
growth driver, in our view
Margins stabilizing as attrition eases and wage hike impacts are behind us
Operating (EBIT) margins for the sector remained stable at 23% in 3QFY11 (vs. 22.9% in
2QFY11). As attrition showed signs of easing for most of the companies in the sector and
we believe wage hike impacts have been largely absorbed, we expect margins to stabilize
over the next year. However, we expect the next cycle of wage hikes along with increased
visa fee cost to impact sector margins in 1QFY12 marginally
HCL Tech and Infosys have the highest operating leverage from utilization
After adding 60,000 employees over the last two quarters, the top 5 companies’ utilization
levels have dropped to 73.1% (-150 bp qoq). At the end of Dec 2010, TCS was the highest
with 77.1%. We believe HCL Tech (at 70.1%) and Infosys (at 72.7%) have enough room to
expand their utilization levels and thereby supporting their EBIT margins over FY12E.
We expect HCL to expand its EBIT margin by 280 bp over the next six quarters and remain
stable by FY13, primarily due to: (1) normalization of attrition and spreading out of high
wages; (2) recovery in BPO business; (3) stabilization of SG&A as deal flow peaked out in
2QFY11; (4) as project ramp-ups get completed, movement towards offshore mix should
increase, resulting in better margins; (5) scale benefits and operational levers, like
utilization, could impact margin positively. We value INFY and HCLT on 12-month
Director’s Cut methodology. Downside risks for INFY and HCLT: currency appreciation,
slowdown in global tech spending.
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