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IT Services
Poised for the next leap
We are upbeat on the demand outlook for India IT services over FY11-13. Despite
the recent sector outperformance, likely earnings upgrades should support
valuations. Large caps should continue to grow their wallet share vs midcaps.
Infosys is our top pick and we have Buys on TCS and HCL Tech as well.
Large caps could see a US-dollar revenue CAGR of more than 20% over FY11-13F
We see our large-cap Indian IT services universe posting an FY11-13F US-dollar revenue
CAGR of more than 20% – despite a high base – notably driven by the following: 1) a better
earnings outlook for clients in key verticals – banking financial services and insurance
(BFSI), retail and manufacturing; 2) major opportunities from the renewal of outsourcing
deals (a total contracted value of US$174bn over the next two years, according to IDC) and
the Indian companies’ growing wallet share of global deals; 3) rising revenue growth from
Europe and discretionary spend from FY12; and 4) other drivers, eg, global sourcing from
emerging verticals, SME business and outsourcing from captives to third-party vendors.
Given the above, we expect Infosys to take a more confident stance on FY12 guidance (due
in April 2011).
Margin challenges look manageable for large caps
Given increasing demand, supply side issues in offshore delivery are likely to pose margin
challenges, in addition to the effect of currency volatility. However, we believe these will be
manageable for the large caps (including Infosys and TCS; we think the worst on margins is
in the past for HCL Tech) thanks to: 1) a likely 1-2% pa improvement in constant-currency
pricing in FY12 and FY13; 2) efficient management of the employee bench and experience
mix given the greater certainty on the IT spend-to-budget ratio in early CY11; and 3) other
levers including scale benefits, improving profitability at subsidiaries and greater offshoring.
It is time to be selective; we recommend Buying Infosys, TCS, HCL Tech
Despite the recent sector outperformance, we expect likely earnings upgrades to support
valuations. We recommend giving a greater weighting to companies with: 1) the appropriate
portfolio mix to capture growing opportunities; and 2) greater headroom in terms of margin
management or a better risk-reward ratio with reasonable valuations. Infosys is our top pick
of the big-four large caps, followed by TCS and HCL Tech. We expect midcaps to struggle
on revenue/earnings growth (we initiate with Holds on MphasiS, which is our preferred
midcap pick, Satyam and Tech Mahindra). Key risks to our positive view are: 1) further
deterioration in Western economies; 2) sharp INR appreciation vs the US dollar; and 3)
austerity and resulting protectionism measures in western economies.
Demand momentum likely to continue
We see a robust demand outlook for Indian IT services over FY11-13, based on an
improved earnings outlook for clients, major opportunities from deal renewals, and other
drivers including improving growth in discretionary spend and European business.
We are initiating coverage on four large-cap Indian IT services stocks (TCS, Infosys, Wipro and
HCL Tech) and on three mid caps (MphasiS, Tech Mahindra and Satyam Computers).
We believe that our Indian IT large caps are poised for the next leap — we estimate the top 4
Indian IT companies (TCS, Infosys, Wipro and HCL Tech) will add incremental revenues of about
US$6bn in FY13 (over FY12), which is similar to their combined revenue in FY05. We see our
large-cap universe posting an FY11-13F CAGR of more than 20% in US dollar revenue despite a
high base. We expect the key drivers to be:
an improved earnings outlook for clients operating in key verticals, namely banking, financial
services and insurance (BFSI), retail and manufacturing;
major opportunities through the renewal of outsourcing deals – IDC estimates a total
contracted value of as high as US$174bn over the next two years – and an increasing wallet
share of global deals for Indian IT services;
improving revenue growth from Europe and discretionary spend from FY12; and
other drivers, including global sourcing from emerging verticals, the growing number of smallmedium
enterprises (SMEs) and outsourcing from captives to third-party vendors.
We examine each of these groups of potential drivers in more detail below.
Improved earnings outlook for clients in key verticals
As shown in Charts 1 and 2, there is a longstanding strong correlation between the revenue
growth of the Indian IT/BPO export sector and the operating earnings growth of S&P 500
companies (reflecting the broader set of clients for the Indian IT industry, especially in the US).
The sharp rebound in operating earnings for the S&P 500 in CY10 was due to a low base effect
from CY08 and CY09. However, after CY10, S&P 500 operating earnings growth to normalise,
although still at the higher end of the historical average (as shown in Chart 1).
As a result, we see continued high growth in S&P 500 operating earnings beyond CY10, ensuring
high volume-growth visibility for Indian IT companies beyond FY11F.
Our forecast for growth in S&P 500 operating earnings in CY12 based on an
annualisation of the 4QCY11 earnings estimate. Our calculations suggest that even if we assume
zero growth qoq from 1QCY12 to 4QCY12, this would result in 6.8% yoy growth in S&P500
operating earnings in CY12. We also find only about 1.2% compounded qoq growth from
1QCY12F to 4QCY12F would be required to achieve 10% yoy growth in S&P 500 operating
earnings in CY12.
Therefore, we believe volume growth visibility for Indian IT is not only robust for FY12, but that it is
also likely to remain high for FY13. As a result, we are positive on the demand outlook for Indian
IT in CY11 and CY12.
Our analysis of S&P 500 operating earnings growth by industry in CY11F (see Table 2) suggests
higher growth for BFSI, retail and manufacturing, traditionally the dominant industries for Indian IT
services. As regards BFSI and retail, we expect this would be most advantageous for Infosys and
TCS given their relatively high exposures to these verticals and their increasing wallet share in
these industries. In manufacturing (covered by the Industrials and Materials sectors in the table),
we believe the worst is over and, given the robust earnings growth outlook (see Table 2), we
expect demand momentum for Indian IT services from this sector to improve from CY11. Again,
this would be beneficial for our top pick, Infosys, given its higher exposure to manufacturing and
its increasing wallet share in the sector (see Table 3).
The following table shows changes in the wallet shares of the top-four Indian IT companies –
Infosys, TCS, Wipro and HCL Tech – in the key verticals from 1QFY10 (April-June 2009) to
3QFY11 (October-December 2010).
We believe 1QFY10 reflected the first signs of stabilisation from the recessionary impact on
volume growth for Indian IT and we therefore use this quarter as a comparison base in referring to
the wallet share of the top-four Indian IT companies across various verticals and services
throughout this report.
Other verticals – notably Telecommunication Services – are likely to remain relatively sluggish in
CY11F (see Table 2). Given Indian IT’s high penetration of outsourcing from this industry, we
expect those vendors with relatively high exposure to this industry, such as Wipro and Tech
Mahindra (TechM), to continue seeing challenges on volume growth visibility.
Our second-level checks also suggest BFSI and retail will outperform
Given our findings above, we have extended our growth analysis by extracting the revenue and
earnings growth of top global companies in some of the major verticals from Bloomberg to arrive
at some lead indicators for growth opportunities for Indian IT.
These checks again clearly indicate that BFSI, retail and, to some extent, manufacturing (our
analysis here was restricted to autos) are likely to present improved growth opportunities even
beyond CY10 for Indian IT. They suggest most global companies operating in these verticals are
likely to register high-single- to double-digit earnings growth in CY11F-12F. One exception is
telecoms, where growth in revenues and earnings is likely to be in the low-single digits for top
global companies.
We forecast increased demand for Indian IT from BFSI and retail, based on robust earnings
growth at clients in these sectors as discussed above.
However, in BFSI, we also see regulatory, compliance and risk-related IT work – from a large set
of clients – keeping demand momentum high in CY11, despite a likely tapering-off in merger and
integration-related work – from a more limited client base.
Among retail companies, we see increasing demand for e-commerce and digitised channels
driving fresh IT investment.
Two of our three Buy-rated stocks – Infosys and TCS – each derive more than 50% of revenues
from BFSI and retail, while Wipro (Hold) and HCL Tech (Buy) derive a lower share of revenues
from these verticals.
However, in the case of HCL Tech, we believe its much higher focus on emerging verticals,
combined with an increasing wallet share in the high-growth services of IMS (infrastructure
management services) and ADM (application development and maintenance) will result in it
posting robust revenue growth going forward.
We are concerned about Wipro’s positioning given its lower concentration on the high-growth
verticals of BFSI and retail, and its relatively high concentration in low-growth verticals, notably
telecoms. As it has been losing wallet share to peers on large deals, we expect Wipro’s revenue
growth to continue lagging that of its peers.
Major opportunities from renewal of large deals
According to global 4QCY10 data from sourcing consultancy TPI, IT deal awards in the
‘restructuring’ category (which includes renegotiations, renewals and extensions) grew 39% yoy –
based on total contracted value (TCV) – in CY10. However there was 25% yoy decline in
outsourcing deal awards in the ‘new scope’ category (growth references in the above two
categories are for deals with a contract value of over US$25m each).
The rise in ‘restructuring’ deals was largely driven by ITO (IT services outsourcing) awards
involving the restructuring of ADM and IMS, both of which are establish service offering for the
Indian IT companies. Most deals awarded in 9MCY10 were bundled deals for ADM plus IMS,
which surged to US$16.6bn from US$8.5bn in 9MCY09, indicating restructuring in these spaces is
on a roll.
India’s wallet share of global contract awards is rising
According to TPI, there was an overall 11% yoy decline in contract awards globally in terms of
TCV (for deals with contract value of more than US$25m each) in CY10. However, the top-four
Indian IT large caps (TCS, Infosys, Wipro and HCL Tech) registered healthy yoy consolidated
revenue growth of around 23% in CY10.
We believe this disconnect is explained by India IT’s increasing wallet share. According to TPI, in
9MCY10, Indian IT’s share of contract awards (for deals with a contract value of more than
US$25m) rose 4ppt yoy to 20% in terms of TCV and 5ppt yoy to 27% in terms of the number of
awards. This, and the increasing activity in restructuring, suggests Indian IT has significant
opportunity in terms of new deal wins through renewals as well as new-scope deal awards in the
coming years.
Major opportunity for Indian IT from large deal renewals
Given Indian IT companies’ increasing wallet share of large deal renewals and new deal awards
globally, the US$174bn worth of renewals in outsourcing contracts over the two years starting
from 4QCY10 – as forecast by IDC – is likely to be a major opportunity for them.
Even if we exclude the IDC forecast of around US$37bn in deal renewals from the government
sector, given the low likelihood of Indian IT companies winning contracts in this sector globally,
this still leaves a balance of around US$137bn in deal renewals and a high number of large deals
with a TCV of more than US$50m (a sweet spot for Indian IT companies as they compete fiercely
with incumbent vendors for deals with TCVs of between US$50m and US$250m).
We expect Indian IT companies’ share in deal renewals to increase
We believe Indian IT companies’ wallet share in large deal renewals is set to increase for the
following reasons:
Indian IT companies typically have a “hardware agnostic” approach, in contrast to some
incumbent global MNCs’ less flexible approach.
Clients’ high demand for spend consolidation is likely to be met more efficiently by new
vendors than by incumbent vendors as a result of legacy issues.
Many large deals that come up for renewal are sole-sourced deals, with only one vendor
servicing the contract, so incumbents face significant pricing pressure from new vendors.
We believe Indian IT companies typically have greater capacity to continue scaling up in
offshoring versus incumbent vendors.
Outsourcing and offshoring is likely to continue to grow
We continue to believe the slowdown in Western economies is driving increased outsourcing and
offshoring, with growth in outsourcing becoming muted during recessionary periods. However,
when volume visibility recovers after periods of sluggish growth in outsourcing/offshoring (as
happens during a recession), this recovery tends to last for two to four years, with accelerated
growth in offshoring. Our view is also reflected in IDC’s predictions for growth in world
We remain believers in offshoring…
We acknowledge that the rise in austerity measures and growing noise on protectionism could act
against the above theory. However, unemployment in technology-related jobs, especially in the
US, is much lower than the national non-farm payrolls average (see Chart 17). In addition, the
number of new computing/communications graduates (bachelors/associate) in the US is falling
each year (see Chart 18).
Therefore, we believe India remains the biggest destination for IT offshoring for the foreseeable
future, given its high number of new English-speaking engineering graduates.
… but strategies for growth in the next decade (FY11F-20F) will need to be more exhaustive
From FY00 to FY10, the Indian IT/BPO services sector achieved robust CAGRs of around 29% in
export revenues through an India-centric FTE-based delivery model relying primarily on cost
arbitrage, tapping the labour pool from major Indian cities, and offering applications development
and maintenance support across the key verticals of BFSI, hi-tech/telecom and manufacturing,
largely to Fortune 500 clients.
However, over the next decade, in addition to continuing growth through the above strategies, we
expect to see an increased focus on growth through new service lines, customers and verticals,
additionally relying on talent from tier-2 and tier-3 Indian cities, and global talent. Elsewhere in this
report, we highlight growth opportunities from emerging verticals and new client bases beyond
Fortune 500-Global 1000 companies, such as SMEs.
Most Western European companies open to renegotiating existing outsourcing contracts
In an IDC survey, more than 50% of Western European (including UK) enterprises said they were
open to renegotiating their existing IT and BPO outsourcing contracts, either to reduce pricing or
to narrow the scope of the deal. Within IT outsourcing contracts, more than 40% of enterprises in
Western Europe (excluding the UK, where the share was even higher) said they were looking to
renegotiate contracts to secure lower prices. Around 50% of the enterprises in Europe said they
were either open to replacing their main service provider or in the process of deciding whether to
do so, with the UK showing the highest tendency
We believe these trends are likely to help increase the Indian IT companies’ wallet share of
outsourcing from Europe. Currently, the Indian IT wallet share of outsourcing contract awards is
lower in EMEA (Europe, the Middle East and Africa) than globally (largely represented by the US).
By verticals, Indian IT also has a weak position in Europe, except in BFSI and telecom.
Outsourcing contract renewals represent a major opportunity for Indian IT, even in the UK
According to IDC, outsourcing contracts worth £52.7bn are due for renewal between 2011 and
2014 in the UK. This TCV is distributed among as many as 590 outsourcing contracts. Even if we
exclude IDC’s estimate of around £16bn in deal renewals in the public sector and healthcare, the
remaining roughly £37bn is sizeable enough for Indian IT and, of course, this relates only to the
UK. The Indian IT share of large deal awards is also significantly lower in EMEA than globally (see
Charts 23 and 24). Therefore the upside potential from this region is very high.
We therefore expect growth in Indian IT’s business from Europe to start inching up from FY12 and
to likely outperform growth in its US business in FY13.
Growth in discretionary spend appears to have returned
Growth in the discretionary portfolio of Indian IT services has been largely driven by enterprise
solutions and consulting rather than by development spending over the past 12-13 quarters (see
Chart 27, which covers just the industry benchmark Infosys). This trend indicates clients have
been opting for customised packaged software rather than customised application development in
recent years.
With both Oracle (NR) and SAP (NR) now seeing yoy licence revenue growth inching into the high
double digits (see Chart 28), we believe the demand momentum for package implementation
services is likely to remain strong as it typically lags licence sales by two to three quarters
Our macro checks also indicate that spending on durable goods (which is largely discretionary) in
the US is recovering faster, which should boost US corporates’ confidence in revenue growth and
their investment in expansion projects. With little scope left for productivity gains for US
corporates, we believe they will be required to invest in expansion, which could drive new project
IT spending. We therefore expect discretionary spend in the US to gather momentum beyond
CY10. However, we are cautious on discretionary IT spend growth in Europe as we believe
corporates remain wary in the context of austerity measures and sovereign debt crises in some
EU periphery countries
As a result, we expect growth in business for the Indian companies from discretionary IT spend to
start inching up from FY12 (especially from the US), which should further increase the growth
momentum. Of our covered stocks, we expect Infosys and HCL Tech to gain the most from these
trends given their higher revenue weighting on discretionary services.
Emerging verticals, SMEs, captive to third-party
outsourcing
High global outsourcing opportunity in emerging verticals
According to a NASSCOM-McKinsey study, the potential annual global outsourcing opportunity
from emerging verticals – including the public sector, healthcare, media and utilities – is likely to
be US$190bn-220bn by 2020. However, although such non-traditional verticals (ie, excluding
BFSI, telecoms, retail and manufacturing) account for 40-45% of global IT spend, the Indian IT
services companies’ exposure to such verticals is minimal, at around 14% of Indian IT-BPO
exports in FY10.
As shown in the table above, the top four Indian IT large caps are increasingly seeking to pursue
the major opportunity of global sourcing from emerging verticals, with their revenue contribution
inching up qoq. This is particularly the case for TCS and HCL Tech, leading to these two
companies taking some wallet share from Wipro.
Outsourcing from captives to third-party vendors – an upcoming opportunity for India
Our analysis of recent trends indicates non-core IT spend is being increasingly outsourced to
third-party vendors from captive or parent entities, resulting in fewer captive companies being
established in recent years in India (see Chart 33). According to NASSCOM Indian captives of
global MNCs posted IT services and BPO revenues of as much as US$6bn in FY09 (around 55%
of their total revenues) – revenues that could be outsourced to third-party vendors in India over
and above the incremental outsourcing to these vendors.
We believe cost efficiencies are much more achievable through the third-party outsourcing model
than through captives in the long term, given the ability to convert fixed costs to variable. This
trend is already emerging, in our opinion, as reflected in various recent acquisitions of captives by
third-party IT vendors (mostly offshore vendors).
Untapped opportunity – SMEs
Indian IT services companies are still predominantly penetrating large enterprises – chiefly
Fortune-500/Global-1000 clients – in developed countries and are less focused on SMEs.
However, in high-income countries, SMEs account for more than 50% of GDP, indicating a huge
unpenetrated opportunity for Indian IT: at present, SMEs contribute less than 15% of Indian IT
revenues.
However, penetrating SMEs would require different business models as SMEs are likely to have
much more limited IT spends (including on hardware, software and services) than larger
companies. We therefore believe that software-as-a-service (SaaS) should be the preferred model
to achieve a higher penetration in SMEs. We see TCS’s positioning as stronger here than its
peers’: it is focused on offering enterprise solutions through SaaS solely in India initially, with a
current client base of around 100. Management has said that it is looking to roll this out across the
globe once it has reached its targeted scale in India.
Margin challenges manageable for large caps
Despite margin headwinds from supply side issues and currency volatility, most Indian IT
large caps should be able to manage margin pressure efficiently through higher pricing
power and scale. However, we think mid caps will likely struggle on margin management.
Given increasing demand, we expect supply-side issues in offshore delivery to pose margin
challenges, in addition to the impact of currency volatility. However, we believe these will be
manageable for the large caps under our coverage (including Infosys and TCS; we think the worst
on margins is in the past for HCL Tech) thanks to the following: 1) a likely 1-2% pa improvement
in constant-currency pricing in FY12 and FY13 (current offshore pricing is 6-7% lower than prerecession
pricing); 2) efficient management of the employee bench and experience mix given the
greater certainty on the IT spend-to-budget ratio in early CY11; and 3) other levers, including
scale benefits, improving profitability at subsidiaries, an increase in offshoring and non-linearity.
Pricing challenges appear to be abating
Recessionary pressures and cross-currency volatility have weighed on pricing since FY08.
Current offshore pricing is lower than that immediately prior to the recession (in late CY07) by 6-
7% in constant currency terms.
However, we believe most large caps are now able to recoup some of the discounts offered
during the recessionary pressures, which should start to be reflected in pricing in the next few
quarters.
We also believe Indian IT services companies have been successful not only in driving the
outsourcing of enterprise solutions, but also in securing follow-up business, the combination of
which turns out to be more profitable, with a resulting margin benefit. We therefore estimate that
constant-currency pricing will rise 1-2% pa over FY12-13.
Flexibility to manage employee experience profile greater in FY12F
As recessionary pressures began to affect outsourcing and offshoring in FY09, most large caps
were in cost-efficiency mode and seeking to improve productivity. This resulted in lower campus
recruitment and a smaller employee bench. However, as recessionary pressures started to ease
from late CY09, with a resulting sudden ramp-up in pent-up demand, there was a significant rise
in demand for lateral employees (typically with more than three years of experience) for project
execution, leading to a much higher attrition rate starting in CY10.
However, we believe that in early CY11 most vendors have clarity on their clients’ budgets and
better visibility on likely ramp-ups in outsourcing and offshoring. This should result in better
planning for fresher recruitment and productive management of the employee bench. We
therefore expect the proportion of employees with less than three years’ experience to start rising
from FY12, which should lead to a major margin tailwind for most large caps.
Table 7 illustrates that every 5ppt change in the employee experience profile – shifting the mix
more towards those with less than three years’ experience – would, all else being equal, result in
EBITDA margin savings of around 100bp. If we assume 20% growth in volumes, but all else is
equal, to achieve a 100bp saving in margins, 55-60% of the vendor’s gross employee additions
that year would need to be freshers, or less-experienced employees (equivalent to around 75% of
net additions). We believe this is not impossible given the relatively low concern about the supply
of freshers, high volume visibility and training infrastructure in place with most vendors.
In the table above, we assume an FY10-14F employee CAGR of 20-22% for the Indian IT
services industry (including both domestic business and exports) and we calculate demand for
newly graduated IT engineers of around 198,000 pa on average over this period. However,
assuming an 8-9% CAGR in the supply of fresh college engineers (only degree holders) over
FY10-14, the available supply of fresh college IT engineers would be around 196,000 pa over the
same period. Our calculation of the supply of fresh engineers is based on the assumption that
around 60% of the total of graduate engineers are IT graduate engineers and 75-80% of these are
willing to join the Indian IT services industry. We have not taken into account: 1) the supply of
holders of MCAs (Masters in computer application), which is around 54,500 pa (in FY10), all of
whom are 100% employable by the IT industry, or 2) the c155,000 supply of diploma holders (in
FY10). Including MCAs and diploma holders, supply is likely to outpace demand by a large
margin.
Given the small gap between demand and supply as shown in Table 8, we therefore see vendors
struggling to secure enough quality employees, especially in the next few years when growth
expectations will likely be high. We therefore expect wage inflation to remain high, even for
employees with limited experience.
Other margin levers
Scale benefits – We recognise that most large-cap companies have already achieved significant
economies of scale, especially in SG&A costs. However, we continue to believe that, despite the
higher base, absolute growth in revenues yoy should be sufficient to drive further scale benefits in
non-employee costs, especially in the SG&A cost line.
Subsidiaries’ profitability – We also believe improving subsidiaries’ profitability will help most
large caps as rising demand should start yielding results on investments made in the subsidiaries.
Offshoring – We expect offshoring to increase, with higher revenue growth in coming years from
renewals of large outsourcing deals.
Utilisation rates – Although most players have already pushed utilisation rates close to historical
highs in recent years, we think that, as the companies grow, new norms on such rates are likely to
emerge soon, resulting in more upward than downward bias.
Non-linearity – With the increasing focus on non-linearity (where revenue growth is less
dependent on employee growth due to increasing revenue contribution from product sales,
software as services, platform based or output based service/revenue model), we believe margins
should benefit in the long term. However, in the short to medium term, we expect an insignificant
impact on margins, given the low scale and higher investment required for non-linear initiatives.
However, we are cautiously optimistic on emerging technologies
We also expect emerging technologies – including cloud computing (offering IT solutions as
services over internet so enabling clients to access data/use the solution from anywhere without
owning the data centre), software-as-a-service (SaaS) and platform-based BPO services – to lead
to a big change in demand dynamics and delivery efforts. We believe that, given the Indian IT
services sector’s proficiency in application development, this should create major opportunities.
But, it would also require a major shift in the delivery model and high investment in the early
years, with margin accretion in the medium to long term. Given the increasing sizes of the large
caps, we think these investments would have no significant adverse impact on margins, and that
they could lead to material margin accretion over the medium to long term once reasonable scale
has been achieved.
However, we are uncertain about the speed at which clients will embrace these technologies
given the various issues surrounding security, data privacy and compliance with regulations,
especially in BFSI, healthcare, etc. We therefore expect it to take another 3-5 years for any major
acceptance of these technologies by clients. We also believe fast adoption of cloud computing is
more likely to happen with peripheral applications/technologies where standardisation can be high
across various industries, such as payroll systems.
In addition, we believe that, in a cloud environment, vendors’ industry domain knowledge will
continue to have higher weighting. We also expect certain services including consulting to remain
onsite/near shore with emergence of cloud factories in global delivery model. Again here, we
believe that the Indian IT services sector can play a major role in delivering cloud solutions from
offshore destinations thanks to its rich experience in current web-based and client/server
architecture and its fast-improving experience across various industries
Valuations – time to be selective
Our optimistic view of the demand outlook for Indian IT leads us to believe the earnings
upgrade cycle will continue, supporting valuations despite recent sector outperformance.
However, we are selective – Buy Infosys, TCS and HCL Tech.
Despite recent sector outperformance, we believe likely upgrades in earnings will support
valuations. We recommend being selective, with higher weighting given to companies with: 1) the
right portfolio mix to address rising opportunities; and 2) high headroom in margin management or
a better risk/reward ratio with reasonable valuations. Based on these themes, Infosys is our top
pick in the big four Indian large caps, followed by TCS and HCL Tech. We expect midcaps to
struggle with revenues/earnings growth (we initiate with Holds on MphasiS – preferred midcap
pick – Satyam and Tech Mahindra).
Large caps dominate Indian IT/BPO export industry
The trend towards total outsourcing (including IT Services+BPO+IMS) is increasing in large deals
and best-of-breed outsourcing is being used more often for project based/discretionary services.
We believe that many midcaps will continue to lose market share going forward considering their
lower scale, lack of end-to-end capability across various industries and high client concentration.
Given rising demand, we believe that management of supply-side issues will be hard for midcaps
as a result of the high attrition in the industry. This will affect midcaps’ margin performance in
addition to their revenue growth being lower than that of large caps. Therefore, we believe the
valuation discount gap between midcaps and large caps is unlikely to narrow significantly.
Cash generation of most large-cap companies in the Indian IT industry has remained higher than
most of the other Indian industries due to efficient working capital management and higher fixedasset
turnover ratio. This has resulted into low gearing for most companies in the Indian IT
industries, with capex requirements largely funded through internal accruals. However, some
large-cap companies (including HCL Tech and Wipro) have taken on material debt to fund
expansion plans through acquisitions. Therefore, we believe that, despite likely higher operational
growth in FY12F/FY13F, most companies’ balance sheets are likely to remain healthy.
Valuation methodology
We expect tier-1 players to continue increasing their market share and their size differentials vs
midcaps. We value Infosys on a forward PE basis, based on its earnings growth potential we see
in FY11-FY13F and its historical forward PE range. Other stocks have been valued on a
discount/premium to Indian IT industry benchmark Infosys based on historical valuation gaps,
quality of growth and any increasing/decreasing business/earnings risks. However, we value
Satyam Computers on a forward EV/EBITDA multiple considering the high volatility of items below
the EBITDA line due to restructuring, as well as various pending litigation issues and their
resulting impact on cash flow, other income and tax provisions.
We believe the revenue wallet share of large-cap companies has gained increasing weight in their
respective fair value multiples and their resulting premiums or discounts to peers, given common
macro drivers for growth and high revenue bases. We expect TCS to trade at a premium to
Infosys in the foreseeable future given TCS’s consistent gain in market share and its EBITDA
margins (especially in its international business, which contributes about 91% of its revenues,
compared with Infosys, for which international business contributes about 98%), which have
caught up to near the industry-leading margins of Infosys. We believe that TCS’s revenue growth
momentum is likely to continue in coming years, despite its much higher base vs peers, and the
possibility of upgrades to our growth estimates cannot be ruled out. However, we expect Wipro,
whose revenues increasingly lag its peers (including Infosys and TCS) despite its lower base and
faces relatively stronger margin headwinds, to trade at discount to Infosys until it shows consistent
improvement in its growth rates. Meanwhile, we expect HCL Tech to continue its valuation
discount gap with Infosys, given its muted margin performance recently and despite our belief that
its revenue growth should remain at the higher end of industry growth rates in coming years. We
believe that the worst on margins is behind it and we expect margins to improve.
We also believe that with expiry of STPI tax benefits, EPS growth for some of the companies is
also likely to be muted over the next two or three years. We believe that EV/EBITDA multiples
should be watched closely by investors during this period, as they would reflect recurring longterm
earnings growth.
Infosys – initiating at Buy; our top pick
We expect high earnings growth momentum for Infosys in the coming years, with its relatively
higher presence in portfolios (including BFSI, retail and discretionary spend) that we see poised
for robust growth. We are convinced about Infosys’s growth strategies, which not only encompass
what it does best (mining potential clients, with the resulting high revenue per client) but also,
increasingly, focus on less-penetrated opportunities and its increasing market share in large
deals. Second, even on margins, we believe that headroom in various factors including utilisations
rates, offshoring, fixed prices, etc, is higher than for some peers, as well as in other factors
including employee pyramids and pricing. Hence, given the lower risk we see to Infosys’s
industry-leading earnings growth, we initiate coverage with a Buy recommendation and a target
price of Rs3,750, offering 21% potential upside. With an expected EPS CAGR of about 23% over
FY11-13F, our target PE of 20.5x for FY13F (almost equivalent to the historical long-term
average) looks reasonable to us, considering the expected high earnings growth momentum from
FY11F to FY13F and the company’s superior cash generation capabilities. Our target price
implies a target EV/EBITDA multiple of 14.0x for FY13F (vs the historical long-term average of
about 15x) with an EBITDA CAGR of about 21% over FY11-13F.
TCS – initiating at Buy
We expect TCS’s revenue growth to remain at the higher end of the peer range, with margin
performance better than Wipro’s given TCS’s increasing market share, sharp management focus
on large deal traction and improving client mining. Hence, we initiate with a Buy recommendation
and target price of Rs1,350, which implies an FY13F PE of 22x (vs EPS CAGR of 18% over
FY11-13F). Our target price implies a target EV/EBITDA multiple of about 15x for FY13F (vs
EBITDA CAGR of about 20% from FY11F to FY13F). Our target PE multiple is at a premium of
about 7% to Infosys’s target PE multiple (vs the current valuation premiums of 12-13% for FY12F
and FY13F) which we believe is fair considering its consistent increase in market share (despite a
higher base) and significant improvement in margins vs peers (including Infosys) despite similar
macro parameters driving each peer’s revenue and earnings growth. We see the risks to our
revenue growth estimates as being to the upside.
Wipro – initiating at Hold
We are concerned that the gap between Wipro’s revenue and those of its peers is widening and
that Wipro has stronger margin headwinds. The company’s declining market share in high-growth
verticals, including BFSI/retail, and relatively high exposure to the likely low-growth verticals,
including telecom, is likely to result in its revenue growth continuing to lag even beyond FY11.
Even the recent change in senior management, with TK Kurien replacing joint CEOs, Suresh
Vaswani and Girish Paranjpe, will take time to improve Wipro’s growth profile, given that the
possibility of a shakeup in senior management by the new CEO could create uncertainty about
near-term execution vs peers. Wipro’s revenue began to lag peers from FY10, with the gap
widening in recent quarters. Wipro’s last one-year average forward-PE discount to peers,
including Infosys, of 13-15% captures this growth lag. We expect the valuation discount to
continue. Hence, we initiate with a Hold rating and a target price of Rs470, which implies an
FY13F PE of 17x, which is at a discount of about 18% to our fair multiple for Infosys (this discount
is marginally higher than the last one-year average), with an EPS CAGR of 14% over FY11-13F
(which is lower than Infosys and TCS). We believe our target PE multiple discount to Infosys is
fair, considering Wipro’s widening gap in qoq revenue growth in recent quarters (despite its lower
base). Our target price implies a target EV/EBITDA multiple of 12x FY13F (on diluted equity), with
EBITDA CAGR of 17% over FY11-13F (much lower than Infosys and TCS). We will review our
PE-based valuation discount to Infosys post any consistently improving signs for Wipro’s growth
profile.
HCL Tech – initiating at Buy
We still to believe that HCL Tech’s focus on IMS and enterprise solutions (both likely to be highgrowth
services going forward) could result in revenue growth higher than the industry average.
We are concerned about recent material decline in margins (on the back of ongoing restructuring
of the business portfolio), but we strongly believe that HCL Tech has more headroom to improve
margins than peers. The recent compromise on margins yielded a much needed increase in its
market share, by 30bp to 14.6%, over 4QFY09-2QFY11, which is the second-largest gain after
that achieved by TCS. Infosys also gained market share, while Wipro lost share during the same
period. Even on margins and profitability, we believe the worst is over for HCL Tech. Therefore,
we believe the risk/reward ratio is favourable and initiate with a Buy rating and a target price of
Rs580, which implies a PE of about 16x for the four quarters ending March 2013 (vs EPS CAGR
of 33% over FY11-13F based on March year-end). Our target price implies a EV/EBITDA of about
10x of four quarters ending March 2013 (vs EBITDA CAGR of 24% over FY11-13F based on
March year-end). Our target PE multiple is at a 20% discount to Infosys, which we believe is fair
looking at long-term historical discount of about 19% (while our target EV/EBITDA multiple is at a
27% discount to Infosys considering HCL Tech’s recent increased gap in margins).
Tech Mahindra – initiating at Hold
We initiate coverage on Tech Mahindra (TechM) with a Hold because we believe that risks such
as high client concentration and focus on a single vertical will likely result in revenue and EBITDA
underperformance vs peers. We strongly believe that for TechM, the margin for error is low vs
peers considering organic business risks and the difficult task of turning around Satyam Computer
(see next paragraph). Therefore, any major valuation re-rating looks unlikely. We initiate with a
Rs650 target price based on sum-of-the-parts valuations: 1) Rs466 for TechM (excluding
Satyam); and 2) Rs184 per TechM share through Satyam. Our target price implies an FY13F PE
multiple of 11x consolidated diluted adjusted EPS (including Satyam but excluding the
amortisation of a one-time revenue receipt from the largest client British Telecom in FY10). This
implies a discount of about 50% to Infosys. The FY13F-based target PE multiple with which we
value TechM (excluding Satyam and based on EPS excluding amortisation of one-time revenue
receipt) is at almost 50% discount to Infosys’s fair multiple, which we believe is fair considering
much higher business risk, much lower EBITDA margins and significantly lower cash-flow
generation. Our FY13F-based target EV/EBITDA multiple values Satyam at about a 60% discount
to Infosys’s fair multiple, which we believe is fair considering its much lower revenue growth
visibility, higher business risk, much lower EBITDA margins and significantly lower cash flow
generation. Key risks to our view include any merger announcement of TechM and Satyam, and
any resulting merger ratio in favour of TechM.
Satyam Computer – initiating at Hold
We are concerned about Satyam’s growth outlook and believe that achieving industry-average
growth will be an uphill task even in FY12F. We strongly believe that margin recovery to near
peers’ levels is a tall task for Satyam even in the long term. Therefore, we believe negative
surprises in operational earnings are likely. Hence we initiate with a Hold rating and a target price
of Rs60 based on an EV/EBITDA target multiple of 5.8x for FY13F, which is at a discount of about
60% to our fair multiple for Infosys. We believe that EV/EBITDA is a better multiple by which to
value the company given the high volatility on items below the EBITDA line due to restructuring as
well as various pending litigation issues and their resulting impact on cash flow, other income and
tax provisions. Key risks to our view include any merger announcement of TechM and Satyam,
and any resulting merger ratio in favour of Satyam.
MphasiS – initiating at Hold
We expect MphasiS’s growth rates to lag peers, given the higher risks we see to growth
momentum in revenues and margins. Recent stock outperformance offers limited upside from
current levels, in our view. Hence, we initiate coverage on MphasiS with a Hold and a target price
of Rs690 which implies a PE of about 12x EPS for the four quarters ending April 2013F (a
discount of about 40% to our fair multiple for Infosys, which is close to the last one-year average
discount). We believe this is fair considering the high risk we see to earnings despite material
business flowing through parent HP, while large cap peers are driving higher growth in direct
business despite much higher bases than MphasiS. However, MphasiS is our preferred midcap
pick given our higher revenue growth forecasts, its higher cash generation capabilities and higher
ROIC. Key risks to our target price include any corporate event including delisting of MphasiS by
parent HP, and any resulting price uptick vs our target price.
Key risks to our optimistic outlook
Indian IT sector’s revenue growth – and therefore sector performance – depends largely on
the macro environment in western economies, given significant revenues coming from the
US and Europe.
Key risk to our optimistic outlook
Any further deterioration in the macro environment in western economies, especially in the US
and Europe.
Any sharp INR appreciation vs the USD. We estimate a 7% appreciation on the average INR
vs the USD in FY10-13F. From the current spot rate of Rs45.6, our average estimate for
FY13F indicates 3.5% appreciation. Besides INR appreciation vs the USD, any depreciation in
other foreign currencies (especially GBP, EUR and AUD) vs the USD affects the USD growth
of Indian IT companies given that a material proportion of their export revenues is
denominated in non-USD currencies.
Austerity and resulting protectionism measures in western economies can affect Indian IT
sector growth given the resulting negative impact on volume growth and/or higher cost of
delivery.
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IT Services
Poised for the next leap
We are upbeat on the demand outlook for India IT services over FY11-13. Despite
the recent sector outperformance, likely earnings upgrades should support
valuations. Large caps should continue to grow their wallet share vs midcaps.
Infosys is our top pick and we have Buys on TCS and HCL Tech as well.
Large caps could see a US-dollar revenue CAGR of more than 20% over FY11-13F
We see our large-cap Indian IT services universe posting an FY11-13F US-dollar revenue
CAGR of more than 20% – despite a high base – notably driven by the following: 1) a better
earnings outlook for clients in key verticals – banking financial services and insurance
(BFSI), retail and manufacturing; 2) major opportunities from the renewal of outsourcing
deals (a total contracted value of US$174bn over the next two years, according to IDC) and
the Indian companies’ growing wallet share of global deals; 3) rising revenue growth from
Europe and discretionary spend from FY12; and 4) other drivers, eg, global sourcing from
emerging verticals, SME business and outsourcing from captives to third-party vendors.
Given the above, we expect Infosys to take a more confident stance on FY12 guidance (due
in April 2011).
Margin challenges look manageable for large caps
Given increasing demand, supply side issues in offshore delivery are likely to pose margin
challenges, in addition to the effect of currency volatility. However, we believe these will be
manageable for the large caps (including Infosys and TCS; we think the worst on margins is
in the past for HCL Tech) thanks to: 1) a likely 1-2% pa improvement in constant-currency
pricing in FY12 and FY13; 2) efficient management of the employee bench and experience
mix given the greater certainty on the IT spend-to-budget ratio in early CY11; and 3) other
levers including scale benefits, improving profitability at subsidiaries and greater offshoring.
It is time to be selective; we recommend Buying Infosys, TCS, HCL Tech
Despite the recent sector outperformance, we expect likely earnings upgrades to support
valuations. We recommend giving a greater weighting to companies with: 1) the appropriate
portfolio mix to capture growing opportunities; and 2) greater headroom in terms of margin
management or a better risk-reward ratio with reasonable valuations. Infosys is our top pick
of the big-four large caps, followed by TCS and HCL Tech. We expect midcaps to struggle
on revenue/earnings growth (we initiate with Holds on MphasiS, which is our preferred
midcap pick, Satyam and Tech Mahindra). Key risks to our positive view are: 1) further
deterioration in Western economies; 2) sharp INR appreciation vs the US dollar; and 3)
austerity and resulting protectionism measures in western economies.
Demand momentum likely to continue
We see a robust demand outlook for Indian IT services over FY11-13, based on an
improved earnings outlook for clients, major opportunities from deal renewals, and other
drivers including improving growth in discretionary spend and European business.
We are initiating coverage on four large-cap Indian IT services stocks (TCS, Infosys, Wipro and
HCL Tech) and on three mid caps (MphasiS, Tech Mahindra and Satyam Computers).
We believe that our Indian IT large caps are poised for the next leap — we estimate the top 4
Indian IT companies (TCS, Infosys, Wipro and HCL Tech) will add incremental revenues of about
US$6bn in FY13 (over FY12), which is similar to their combined revenue in FY05. We see our
large-cap universe posting an FY11-13F CAGR of more than 20% in US dollar revenue despite a
high base. We expect the key drivers to be:
an improved earnings outlook for clients operating in key verticals, namely banking, financial
services and insurance (BFSI), retail and manufacturing;
major opportunities through the renewal of outsourcing deals – IDC estimates a total
contracted value of as high as US$174bn over the next two years – and an increasing wallet
share of global deals for Indian IT services;
improving revenue growth from Europe and discretionary spend from FY12; and
other drivers, including global sourcing from emerging verticals, the growing number of smallmedium
enterprises (SMEs) and outsourcing from captives to third-party vendors.
We examine each of these groups of potential drivers in more detail below.
Improved earnings outlook for clients in key verticals
As shown in Charts 1 and 2, there is a longstanding strong correlation between the revenue
growth of the Indian IT/BPO export sector and the operating earnings growth of S&P 500
companies (reflecting the broader set of clients for the Indian IT industry, especially in the US).
The sharp rebound in operating earnings for the S&P 500 in CY10 was due to a low base effect
from CY08 and CY09. However, after CY10, S&P 500 operating earnings growth to normalise,
although still at the higher end of the historical average (as shown in Chart 1).
As a result, we see continued high growth in S&P 500 operating earnings beyond CY10, ensuring
high volume-growth visibility for Indian IT companies beyond FY11F.
Our forecast for growth in S&P 500 operating earnings in CY12 based on an
annualisation of the 4QCY11 earnings estimate. Our calculations suggest that even if we assume
zero growth qoq from 1QCY12 to 4QCY12, this would result in 6.8% yoy growth in S&P500
operating earnings in CY12. We also find only about 1.2% compounded qoq growth from
1QCY12F to 4QCY12F would be required to achieve 10% yoy growth in S&P 500 operating
earnings in CY12.
Therefore, we believe volume growth visibility for Indian IT is not only robust for FY12, but that it is
also likely to remain high for FY13. As a result, we are positive on the demand outlook for Indian
IT in CY11 and CY12.
Our analysis of S&P 500 operating earnings growth by industry in CY11F (see Table 2) suggests
higher growth for BFSI, retail and manufacturing, traditionally the dominant industries for Indian IT
services. As regards BFSI and retail, we expect this would be most advantageous for Infosys and
TCS given their relatively high exposures to these verticals and their increasing wallet share in
these industries. In manufacturing (covered by the Industrials and Materials sectors in the table),
we believe the worst is over and, given the robust earnings growth outlook (see Table 2), we
expect demand momentum for Indian IT services from this sector to improve from CY11. Again,
this would be beneficial for our top pick, Infosys, given its higher exposure to manufacturing and
its increasing wallet share in the sector (see Table 3).
The following table shows changes in the wallet shares of the top-four Indian IT companies –
Infosys, TCS, Wipro and HCL Tech – in the key verticals from 1QFY10 (April-June 2009) to
3QFY11 (October-December 2010).
We believe 1QFY10 reflected the first signs of stabilisation from the recessionary impact on
volume growth for Indian IT and we therefore use this quarter as a comparison base in referring to
the wallet share of the top-four Indian IT companies across various verticals and services
throughout this report.
Other verticals – notably Telecommunication Services – are likely to remain relatively sluggish in
CY11F (see Table 2). Given Indian IT’s high penetration of outsourcing from this industry, we
expect those vendors with relatively high exposure to this industry, such as Wipro and Tech
Mahindra (TechM), to continue seeing challenges on volume growth visibility.
Our second-level checks also suggest BFSI and retail will outperform
Given our findings above, we have extended our growth analysis by extracting the revenue and
earnings growth of top global companies in some of the major verticals from Bloomberg to arrive
at some lead indicators for growth opportunities for Indian IT.
These checks again clearly indicate that BFSI, retail and, to some extent, manufacturing (our
analysis here was restricted to autos) are likely to present improved growth opportunities even
beyond CY10 for Indian IT. They suggest most global companies operating in these verticals are
likely to register high-single- to double-digit earnings growth in CY11F-12F. One exception is
telecoms, where growth in revenues and earnings is likely to be in the low-single digits for top
global companies.
We forecast increased demand for Indian IT from BFSI and retail, based on robust earnings
growth at clients in these sectors as discussed above.
However, in BFSI, we also see regulatory, compliance and risk-related IT work – from a large set
of clients – keeping demand momentum high in CY11, despite a likely tapering-off in merger and
integration-related work – from a more limited client base.
Among retail companies, we see increasing demand for e-commerce and digitised channels
driving fresh IT investment.
Two of our three Buy-rated stocks – Infosys and TCS – each derive more than 50% of revenues
from BFSI and retail, while Wipro (Hold) and HCL Tech (Buy) derive a lower share of revenues
from these verticals.
However, in the case of HCL Tech, we believe its much higher focus on emerging verticals,
combined with an increasing wallet share in the high-growth services of IMS (infrastructure
management services) and ADM (application development and maintenance) will result in it
posting robust revenue growth going forward.
We are concerned about Wipro’s positioning given its lower concentration on the high-growth
verticals of BFSI and retail, and its relatively high concentration in low-growth verticals, notably
telecoms. As it has been losing wallet share to peers on large deals, we expect Wipro’s revenue
growth to continue lagging that of its peers.
Major opportunities from renewal of large deals
According to global 4QCY10 data from sourcing consultancy TPI, IT deal awards in the
‘restructuring’ category (which includes renegotiations, renewals and extensions) grew 39% yoy –
based on total contracted value (TCV) – in CY10. However there was 25% yoy decline in
outsourcing deal awards in the ‘new scope’ category (growth references in the above two
categories are for deals with a contract value of over US$25m each).
The rise in ‘restructuring’ deals was largely driven by ITO (IT services outsourcing) awards
involving the restructuring of ADM and IMS, both of which are establish service offering for the
Indian IT companies. Most deals awarded in 9MCY10 were bundled deals for ADM plus IMS,
which surged to US$16.6bn from US$8.5bn in 9MCY09, indicating restructuring in these spaces is
on a roll.
India’s wallet share of global contract awards is rising
According to TPI, there was an overall 11% yoy decline in contract awards globally in terms of
TCV (for deals with contract value of more than US$25m each) in CY10. However, the top-four
Indian IT large caps (TCS, Infosys, Wipro and HCL Tech) registered healthy yoy consolidated
revenue growth of around 23% in CY10.
We believe this disconnect is explained by India IT’s increasing wallet share. According to TPI, in
9MCY10, Indian IT’s share of contract awards (for deals with a contract value of more than
US$25m) rose 4ppt yoy to 20% in terms of TCV and 5ppt yoy to 27% in terms of the number of
awards. This, and the increasing activity in restructuring, suggests Indian IT has significant
opportunity in terms of new deal wins through renewals as well as new-scope deal awards in the
coming years.
Major opportunity for Indian IT from large deal renewals
Given Indian IT companies’ increasing wallet share of large deal renewals and new deal awards
globally, the US$174bn worth of renewals in outsourcing contracts over the two years starting
from 4QCY10 – as forecast by IDC – is likely to be a major opportunity for them.
Even if we exclude the IDC forecast of around US$37bn in deal renewals from the government
sector, given the low likelihood of Indian IT companies winning contracts in this sector globally,
this still leaves a balance of around US$137bn in deal renewals and a high number of large deals
with a TCV of more than US$50m (a sweet spot for Indian IT companies as they compete fiercely
with incumbent vendors for deals with TCVs of between US$50m and US$250m).
We expect Indian IT companies’ share in deal renewals to increase
We believe Indian IT companies’ wallet share in large deal renewals is set to increase for the
following reasons:
Indian IT companies typically have a “hardware agnostic” approach, in contrast to some
incumbent global MNCs’ less flexible approach.
Clients’ high demand for spend consolidation is likely to be met more efficiently by new
vendors than by incumbent vendors as a result of legacy issues.
Many large deals that come up for renewal are sole-sourced deals, with only one vendor
servicing the contract, so incumbents face significant pricing pressure from new vendors.
We believe Indian IT companies typically have greater capacity to continue scaling up in
offshoring versus incumbent vendors.
Outsourcing and offshoring is likely to continue to grow
We continue to believe the slowdown in Western economies is driving increased outsourcing and
offshoring, with growth in outsourcing becoming muted during recessionary periods. However,
when volume visibility recovers after periods of sluggish growth in outsourcing/offshoring (as
happens during a recession), this recovery tends to last for two to four years, with accelerated
growth in offshoring. Our view is also reflected in IDC’s predictions for growth in world
We remain believers in offshoring…
We acknowledge that the rise in austerity measures and growing noise on protectionism could act
against the above theory. However, unemployment in technology-related jobs, especially in the
US, is much lower than the national non-farm payrolls average (see Chart 17). In addition, the
number of new computing/communications graduates (bachelors/associate) in the US is falling
each year (see Chart 18).
Therefore, we believe India remains the biggest destination for IT offshoring for the foreseeable
future, given its high number of new English-speaking engineering graduates.
… but strategies for growth in the next decade (FY11F-20F) will need to be more exhaustive
From FY00 to FY10, the Indian IT/BPO services sector achieved robust CAGRs of around 29% in
export revenues through an India-centric FTE-based delivery model relying primarily on cost
arbitrage, tapping the labour pool from major Indian cities, and offering applications development
and maintenance support across the key verticals of BFSI, hi-tech/telecom and manufacturing,
largely to Fortune 500 clients.
However, over the next decade, in addition to continuing growth through the above strategies, we
expect to see an increased focus on growth through new service lines, customers and verticals,
additionally relying on talent from tier-2 and tier-3 Indian cities, and global talent. Elsewhere in this
report, we highlight growth opportunities from emerging verticals and new client bases beyond
Fortune 500-Global 1000 companies, such as SMEs.
Most Western European companies open to renegotiating existing outsourcing contracts
In an IDC survey, more than 50% of Western European (including UK) enterprises said they were
open to renegotiating their existing IT and BPO outsourcing contracts, either to reduce pricing or
to narrow the scope of the deal. Within IT outsourcing contracts, more than 40% of enterprises in
Western Europe (excluding the UK, where the share was even higher) said they were looking to
renegotiate contracts to secure lower prices. Around 50% of the enterprises in Europe said they
were either open to replacing their main service provider or in the process of deciding whether to
do so, with the UK showing the highest tendency
We believe these trends are likely to help increase the Indian IT companies’ wallet share of
outsourcing from Europe. Currently, the Indian IT wallet share of outsourcing contract awards is
lower in EMEA (Europe, the Middle East and Africa) than globally (largely represented by the US).
By verticals, Indian IT also has a weak position in Europe, except in BFSI and telecom.
Outsourcing contract renewals represent a major opportunity for Indian IT, even in the UK
According to IDC, outsourcing contracts worth £52.7bn are due for renewal between 2011 and
2014 in the UK. This TCV is distributed among as many as 590 outsourcing contracts. Even if we
exclude IDC’s estimate of around £16bn in deal renewals in the public sector and healthcare, the
remaining roughly £37bn is sizeable enough for Indian IT and, of course, this relates only to the
UK. The Indian IT share of large deal awards is also significantly lower in EMEA than globally (see
Charts 23 and 24). Therefore the upside potential from this region is very high.
We therefore expect growth in Indian IT’s business from Europe to start inching up from FY12 and
to likely outperform growth in its US business in FY13.
Growth in discretionary spend appears to have returned
Growth in the discretionary portfolio of Indian IT services has been largely driven by enterprise
solutions and consulting rather than by development spending over the past 12-13 quarters (see
Chart 27, which covers just the industry benchmark Infosys). This trend indicates clients have
been opting for customised packaged software rather than customised application development in
recent years.
With both Oracle (NR) and SAP (NR) now seeing yoy licence revenue growth inching into the high
double digits (see Chart 28), we believe the demand momentum for package implementation
services is likely to remain strong as it typically lags licence sales by two to three quarters
Our macro checks also indicate that spending on durable goods (which is largely discretionary) in
the US is recovering faster, which should boost US corporates’ confidence in revenue growth and
their investment in expansion projects. With little scope left for productivity gains for US
corporates, we believe they will be required to invest in expansion, which could drive new project
IT spending. We therefore expect discretionary spend in the US to gather momentum beyond
CY10. However, we are cautious on discretionary IT spend growth in Europe as we believe
corporates remain wary in the context of austerity measures and sovereign debt crises in some
EU periphery countries
As a result, we expect growth in business for the Indian companies from discretionary IT spend to
start inching up from FY12 (especially from the US), which should further increase the growth
momentum. Of our covered stocks, we expect Infosys and HCL Tech to gain the most from these
trends given their higher revenue weighting on discretionary services.
Emerging verticals, SMEs, captive to third-party
outsourcing
High global outsourcing opportunity in emerging verticals
According to a NASSCOM-McKinsey study, the potential annual global outsourcing opportunity
from emerging verticals – including the public sector, healthcare, media and utilities – is likely to
be US$190bn-220bn by 2020. However, although such non-traditional verticals (ie, excluding
BFSI, telecoms, retail and manufacturing) account for 40-45% of global IT spend, the Indian IT
services companies’ exposure to such verticals is minimal, at around 14% of Indian IT-BPO
exports in FY10.
As shown in the table above, the top four Indian IT large caps are increasingly seeking to pursue
the major opportunity of global sourcing from emerging verticals, with their revenue contribution
inching up qoq. This is particularly the case for TCS and HCL Tech, leading to these two
companies taking some wallet share from Wipro.
Outsourcing from captives to third-party vendors – an upcoming opportunity for India
Our analysis of recent trends indicates non-core IT spend is being increasingly outsourced to
third-party vendors from captive or parent entities, resulting in fewer captive companies being
established in recent years in India (see Chart 33). According to NASSCOM Indian captives of
global MNCs posted IT services and BPO revenues of as much as US$6bn in FY09 (around 55%
of their total revenues) – revenues that could be outsourced to third-party vendors in India over
and above the incremental outsourcing to these vendors.
We believe cost efficiencies are much more achievable through the third-party outsourcing model
than through captives in the long term, given the ability to convert fixed costs to variable. This
trend is already emerging, in our opinion, as reflected in various recent acquisitions of captives by
third-party IT vendors (mostly offshore vendors).
Untapped opportunity – SMEs
Indian IT services companies are still predominantly penetrating large enterprises – chiefly
Fortune-500/Global-1000 clients – in developed countries and are less focused on SMEs.
However, in high-income countries, SMEs account for more than 50% of GDP, indicating a huge
unpenetrated opportunity for Indian IT: at present, SMEs contribute less than 15% of Indian IT
revenues.
However, penetrating SMEs would require different business models as SMEs are likely to have
much more limited IT spends (including on hardware, software and services) than larger
companies. We therefore believe that software-as-a-service (SaaS) should be the preferred model
to achieve a higher penetration in SMEs. We see TCS’s positioning as stronger here than its
peers’: it is focused on offering enterprise solutions through SaaS solely in India initially, with a
current client base of around 100. Management has said that it is looking to roll this out across the
globe once it has reached its targeted scale in India.
Margin challenges manageable for large caps
Despite margin headwinds from supply side issues and currency volatility, most Indian IT
large caps should be able to manage margin pressure efficiently through higher pricing
power and scale. However, we think mid caps will likely struggle on margin management.
Given increasing demand, we expect supply-side issues in offshore delivery to pose margin
challenges, in addition to the impact of currency volatility. However, we believe these will be
manageable for the large caps under our coverage (including Infosys and TCS; we think the worst
on margins is in the past for HCL Tech) thanks to the following: 1) a likely 1-2% pa improvement
in constant-currency pricing in FY12 and FY13 (current offshore pricing is 6-7% lower than prerecession
pricing); 2) efficient management of the employee bench and experience mix given the
greater certainty on the IT spend-to-budget ratio in early CY11; and 3) other levers, including
scale benefits, improving profitability at subsidiaries, an increase in offshoring and non-linearity.
Pricing challenges appear to be abating
Recessionary pressures and cross-currency volatility have weighed on pricing since FY08.
Current offshore pricing is lower than that immediately prior to the recession (in late CY07) by 6-
7% in constant currency terms.
However, we believe most large caps are now able to recoup some of the discounts offered
during the recessionary pressures, which should start to be reflected in pricing in the next few
quarters.
We also believe Indian IT services companies have been successful not only in driving the
outsourcing of enterprise solutions, but also in securing follow-up business, the combination of
which turns out to be more profitable, with a resulting margin benefit. We therefore estimate that
constant-currency pricing will rise 1-2% pa over FY12-13.
Flexibility to manage employee experience profile greater in FY12F
As recessionary pressures began to affect outsourcing and offshoring in FY09, most large caps
were in cost-efficiency mode and seeking to improve productivity. This resulted in lower campus
recruitment and a smaller employee bench. However, as recessionary pressures started to ease
from late CY09, with a resulting sudden ramp-up in pent-up demand, there was a significant rise
in demand for lateral employees (typically with more than three years of experience) for project
execution, leading to a much higher attrition rate starting in CY10.
However, we believe that in early CY11 most vendors have clarity on their clients’ budgets and
better visibility on likely ramp-ups in outsourcing and offshoring. This should result in better
planning for fresher recruitment and productive management of the employee bench. We
therefore expect the proportion of employees with less than three years’ experience to start rising
from FY12, which should lead to a major margin tailwind for most large caps.
Table 7 illustrates that every 5ppt change in the employee experience profile – shifting the mix
more towards those with less than three years’ experience – would, all else being equal, result in
EBITDA margin savings of around 100bp. If we assume 20% growth in volumes, but all else is
equal, to achieve a 100bp saving in margins, 55-60% of the vendor’s gross employee additions
that year would need to be freshers, or less-experienced employees (equivalent to around 75% of
net additions). We believe this is not impossible given the relatively low concern about the supply
of freshers, high volume visibility and training infrastructure in place with most vendors.
In the table above, we assume an FY10-14F employee CAGR of 20-22% for the Indian IT
services industry (including both domestic business and exports) and we calculate demand for
newly graduated IT engineers of around 198,000 pa on average over this period. However,
assuming an 8-9% CAGR in the supply of fresh college engineers (only degree holders) over
FY10-14, the available supply of fresh college IT engineers would be around 196,000 pa over the
same period. Our calculation of the supply of fresh engineers is based on the assumption that
around 60% of the total of graduate engineers are IT graduate engineers and 75-80% of these are
willing to join the Indian IT services industry. We have not taken into account: 1) the supply of
holders of MCAs (Masters in computer application), which is around 54,500 pa (in FY10), all of
whom are 100% employable by the IT industry, or 2) the c155,000 supply of diploma holders (in
FY10). Including MCAs and diploma holders, supply is likely to outpace demand by a large
margin.
Given the small gap between demand and supply as shown in Table 8, we therefore see vendors
struggling to secure enough quality employees, especially in the next few years when growth
expectations will likely be high. We therefore expect wage inflation to remain high, even for
employees with limited experience.
Other margin levers
Scale benefits – We recognise that most large-cap companies have already achieved significant
economies of scale, especially in SG&A costs. However, we continue to believe that, despite the
higher base, absolute growth in revenues yoy should be sufficient to drive further scale benefits in
non-employee costs, especially in the SG&A cost line.
Subsidiaries’ profitability – We also believe improving subsidiaries’ profitability will help most
large caps as rising demand should start yielding results on investments made in the subsidiaries.
Offshoring – We expect offshoring to increase, with higher revenue growth in coming years from
renewals of large outsourcing deals.
Utilisation rates – Although most players have already pushed utilisation rates close to historical
highs in recent years, we think that, as the companies grow, new norms on such rates are likely to
emerge soon, resulting in more upward than downward bias.
Non-linearity – With the increasing focus on non-linearity (where revenue growth is less
dependent on employee growth due to increasing revenue contribution from product sales,
software as services, platform based or output based service/revenue model), we believe margins
should benefit in the long term. However, in the short to medium term, we expect an insignificant
impact on margins, given the low scale and higher investment required for non-linear initiatives.
However, we are cautiously optimistic on emerging technologies
We also expect emerging technologies – including cloud computing (offering IT solutions as
services over internet so enabling clients to access data/use the solution from anywhere without
owning the data centre), software-as-a-service (SaaS) and platform-based BPO services – to lead
to a big change in demand dynamics and delivery efforts. We believe that, given the Indian IT
services sector’s proficiency in application development, this should create major opportunities.
But, it would also require a major shift in the delivery model and high investment in the early
years, with margin accretion in the medium to long term. Given the increasing sizes of the large
caps, we think these investments would have no significant adverse impact on margins, and that
they could lead to material margin accretion over the medium to long term once reasonable scale
has been achieved.
However, we are uncertain about the speed at which clients will embrace these technologies
given the various issues surrounding security, data privacy and compliance with regulations,
especially in BFSI, healthcare, etc. We therefore expect it to take another 3-5 years for any major
acceptance of these technologies by clients. We also believe fast adoption of cloud computing is
more likely to happen with peripheral applications/technologies where standardisation can be high
across various industries, such as payroll systems.
In addition, we believe that, in a cloud environment, vendors’ industry domain knowledge will
continue to have higher weighting. We also expect certain services including consulting to remain
onsite/near shore with emergence of cloud factories in global delivery model. Again here, we
believe that the Indian IT services sector can play a major role in delivering cloud solutions from
offshore destinations thanks to its rich experience in current web-based and client/server
architecture and its fast-improving experience across various industries
Valuations – time to be selective
Our optimistic view of the demand outlook for Indian IT leads us to believe the earnings
upgrade cycle will continue, supporting valuations despite recent sector outperformance.
However, we are selective – Buy Infosys, TCS and HCL Tech.
Despite recent sector outperformance, we believe likely upgrades in earnings will support
valuations. We recommend being selective, with higher weighting given to companies with: 1) the
right portfolio mix to address rising opportunities; and 2) high headroom in margin management or
a better risk/reward ratio with reasonable valuations. Based on these themes, Infosys is our top
pick in the big four Indian large caps, followed by TCS and HCL Tech. We expect midcaps to
struggle with revenues/earnings growth (we initiate with Holds on MphasiS – preferred midcap
pick – Satyam and Tech Mahindra).
Large caps dominate Indian IT/BPO export industry
The trend towards total outsourcing (including IT Services+BPO+IMS) is increasing in large deals
and best-of-breed outsourcing is being used more often for project based/discretionary services.
We believe that many midcaps will continue to lose market share going forward considering their
lower scale, lack of end-to-end capability across various industries and high client concentration.
Given rising demand, we believe that management of supply-side issues will be hard for midcaps
as a result of the high attrition in the industry. This will affect midcaps’ margin performance in
addition to their revenue growth being lower than that of large caps. Therefore, we believe the
valuation discount gap between midcaps and large caps is unlikely to narrow significantly.
Cash generation of most large-cap companies in the Indian IT industry has remained higher than
most of the other Indian industries due to efficient working capital management and higher fixedasset
turnover ratio. This has resulted into low gearing for most companies in the Indian IT
industries, with capex requirements largely funded through internal accruals. However, some
large-cap companies (including HCL Tech and Wipro) have taken on material debt to fund
expansion plans through acquisitions. Therefore, we believe that, despite likely higher operational
growth in FY12F/FY13F, most companies’ balance sheets are likely to remain healthy.
Valuation methodology
We expect tier-1 players to continue increasing their market share and their size differentials vs
midcaps. We value Infosys on a forward PE basis, based on its earnings growth potential we see
in FY11-FY13F and its historical forward PE range. Other stocks have been valued on a
discount/premium to Indian IT industry benchmark Infosys based on historical valuation gaps,
quality of growth and any increasing/decreasing business/earnings risks. However, we value
Satyam Computers on a forward EV/EBITDA multiple considering the high volatility of items below
the EBITDA line due to restructuring, as well as various pending litigation issues and their
resulting impact on cash flow, other income and tax provisions.
We believe the revenue wallet share of large-cap companies has gained increasing weight in their
respective fair value multiples and their resulting premiums or discounts to peers, given common
macro drivers for growth and high revenue bases. We expect TCS to trade at a premium to
Infosys in the foreseeable future given TCS’s consistent gain in market share and its EBITDA
margins (especially in its international business, which contributes about 91% of its revenues,
compared with Infosys, for which international business contributes about 98%), which have
caught up to near the industry-leading margins of Infosys. We believe that TCS’s revenue growth
momentum is likely to continue in coming years, despite its much higher base vs peers, and the
possibility of upgrades to our growth estimates cannot be ruled out. However, we expect Wipro,
whose revenues increasingly lag its peers (including Infosys and TCS) despite its lower base and
faces relatively stronger margin headwinds, to trade at discount to Infosys until it shows consistent
improvement in its growth rates. Meanwhile, we expect HCL Tech to continue its valuation
discount gap with Infosys, given its muted margin performance recently and despite our belief that
its revenue growth should remain at the higher end of industry growth rates in coming years. We
believe that the worst on margins is behind it and we expect margins to improve.
We also believe that with expiry of STPI tax benefits, EPS growth for some of the companies is
also likely to be muted over the next two or three years. We believe that EV/EBITDA multiples
should be watched closely by investors during this period, as they would reflect recurring longterm
earnings growth.
Infosys – initiating at Buy; our top pick
We expect high earnings growth momentum for Infosys in the coming years, with its relatively
higher presence in portfolios (including BFSI, retail and discretionary spend) that we see poised
for robust growth. We are convinced about Infosys’s growth strategies, which not only encompass
what it does best (mining potential clients, with the resulting high revenue per client) but also,
increasingly, focus on less-penetrated opportunities and its increasing market share in large
deals. Second, even on margins, we believe that headroom in various factors including utilisations
rates, offshoring, fixed prices, etc, is higher than for some peers, as well as in other factors
including employee pyramids and pricing. Hence, given the lower risk we see to Infosys’s
industry-leading earnings growth, we initiate coverage with a Buy recommendation and a target
price of Rs3,750, offering 21% potential upside. With an expected EPS CAGR of about 23% over
FY11-13F, our target PE of 20.5x for FY13F (almost equivalent to the historical long-term
average) looks reasonable to us, considering the expected high earnings growth momentum from
FY11F to FY13F and the company’s superior cash generation capabilities. Our target price
implies a target EV/EBITDA multiple of 14.0x for FY13F (vs the historical long-term average of
about 15x) with an EBITDA CAGR of about 21% over FY11-13F.
TCS – initiating at Buy
We expect TCS’s revenue growth to remain at the higher end of the peer range, with margin
performance better than Wipro’s given TCS’s increasing market share, sharp management focus
on large deal traction and improving client mining. Hence, we initiate with a Buy recommendation
and target price of Rs1,350, which implies an FY13F PE of 22x (vs EPS CAGR of 18% over
FY11-13F). Our target price implies a target EV/EBITDA multiple of about 15x for FY13F (vs
EBITDA CAGR of about 20% from FY11F to FY13F). Our target PE multiple is at a premium of
about 7% to Infosys’s target PE multiple (vs the current valuation premiums of 12-13% for FY12F
and FY13F) which we believe is fair considering its consistent increase in market share (despite a
higher base) and significant improvement in margins vs peers (including Infosys) despite similar
macro parameters driving each peer’s revenue and earnings growth. We see the risks to our
revenue growth estimates as being to the upside.
Wipro – initiating at Hold
We are concerned that the gap between Wipro’s revenue and those of its peers is widening and
that Wipro has stronger margin headwinds. The company’s declining market share in high-growth
verticals, including BFSI/retail, and relatively high exposure to the likely low-growth verticals,
including telecom, is likely to result in its revenue growth continuing to lag even beyond FY11.
Even the recent change in senior management, with TK Kurien replacing joint CEOs, Suresh
Vaswani and Girish Paranjpe, will take time to improve Wipro’s growth profile, given that the
possibility of a shakeup in senior management by the new CEO could create uncertainty about
near-term execution vs peers. Wipro’s revenue began to lag peers from FY10, with the gap
widening in recent quarters. Wipro’s last one-year average forward-PE discount to peers,
including Infosys, of 13-15% captures this growth lag. We expect the valuation discount to
continue. Hence, we initiate with a Hold rating and a target price of Rs470, which implies an
FY13F PE of 17x, which is at a discount of about 18% to our fair multiple for Infosys (this discount
is marginally higher than the last one-year average), with an EPS CAGR of 14% over FY11-13F
(which is lower than Infosys and TCS). We believe our target PE multiple discount to Infosys is
fair, considering Wipro’s widening gap in qoq revenue growth in recent quarters (despite its lower
base). Our target price implies a target EV/EBITDA multiple of 12x FY13F (on diluted equity), with
EBITDA CAGR of 17% over FY11-13F (much lower than Infosys and TCS). We will review our
PE-based valuation discount to Infosys post any consistently improving signs for Wipro’s growth
profile.
HCL Tech – initiating at Buy
We still to believe that HCL Tech’s focus on IMS and enterprise solutions (both likely to be highgrowth
services going forward) could result in revenue growth higher than the industry average.
We are concerned about recent material decline in margins (on the back of ongoing restructuring
of the business portfolio), but we strongly believe that HCL Tech has more headroom to improve
margins than peers. The recent compromise on margins yielded a much needed increase in its
market share, by 30bp to 14.6%, over 4QFY09-2QFY11, which is the second-largest gain after
that achieved by TCS. Infosys also gained market share, while Wipro lost share during the same
period. Even on margins and profitability, we believe the worst is over for HCL Tech. Therefore,
we believe the risk/reward ratio is favourable and initiate with a Buy rating and a target price of
Rs580, which implies a PE of about 16x for the four quarters ending March 2013 (vs EPS CAGR
of 33% over FY11-13F based on March year-end). Our target price implies a EV/EBITDA of about
10x of four quarters ending March 2013 (vs EBITDA CAGR of 24% over FY11-13F based on
March year-end). Our target PE multiple is at a 20% discount to Infosys, which we believe is fair
looking at long-term historical discount of about 19% (while our target EV/EBITDA multiple is at a
27% discount to Infosys considering HCL Tech’s recent increased gap in margins).
Tech Mahindra – initiating at Hold
We initiate coverage on Tech Mahindra (TechM) with a Hold because we believe that risks such
as high client concentration and focus on a single vertical will likely result in revenue and EBITDA
underperformance vs peers. We strongly believe that for TechM, the margin for error is low vs
peers considering organic business risks and the difficult task of turning around Satyam Computer
(see next paragraph). Therefore, any major valuation re-rating looks unlikely. We initiate with a
Rs650 target price based on sum-of-the-parts valuations: 1) Rs466 for TechM (excluding
Satyam); and 2) Rs184 per TechM share through Satyam. Our target price implies an FY13F PE
multiple of 11x consolidated diluted adjusted EPS (including Satyam but excluding the
amortisation of a one-time revenue receipt from the largest client British Telecom in FY10). This
implies a discount of about 50% to Infosys. The FY13F-based target PE multiple with which we
value TechM (excluding Satyam and based on EPS excluding amortisation of one-time revenue
receipt) is at almost 50% discount to Infosys’s fair multiple, which we believe is fair considering
much higher business risk, much lower EBITDA margins and significantly lower cash-flow
generation. Our FY13F-based target EV/EBITDA multiple values Satyam at about a 60% discount
to Infosys’s fair multiple, which we believe is fair considering its much lower revenue growth
visibility, higher business risk, much lower EBITDA margins and significantly lower cash flow
generation. Key risks to our view include any merger announcement of TechM and Satyam, and
any resulting merger ratio in favour of TechM.
Satyam Computer – initiating at Hold
We are concerned about Satyam’s growth outlook and believe that achieving industry-average
growth will be an uphill task even in FY12F. We strongly believe that margin recovery to near
peers’ levels is a tall task for Satyam even in the long term. Therefore, we believe negative
surprises in operational earnings are likely. Hence we initiate with a Hold rating and a target price
of Rs60 based on an EV/EBITDA target multiple of 5.8x for FY13F, which is at a discount of about
60% to our fair multiple for Infosys. We believe that EV/EBITDA is a better multiple by which to
value the company given the high volatility on items below the EBITDA line due to restructuring as
well as various pending litigation issues and their resulting impact on cash flow, other income and
tax provisions. Key risks to our view include any merger announcement of TechM and Satyam,
and any resulting merger ratio in favour of Satyam.
MphasiS – initiating at Hold
We expect MphasiS’s growth rates to lag peers, given the higher risks we see to growth
momentum in revenues and margins. Recent stock outperformance offers limited upside from
current levels, in our view. Hence, we initiate coverage on MphasiS with a Hold and a target price
of Rs690 which implies a PE of about 12x EPS for the four quarters ending April 2013F (a
discount of about 40% to our fair multiple for Infosys, which is close to the last one-year average
discount). We believe this is fair considering the high risk we see to earnings despite material
business flowing through parent HP, while large cap peers are driving higher growth in direct
business despite much higher bases than MphasiS. However, MphasiS is our preferred midcap
pick given our higher revenue growth forecasts, its higher cash generation capabilities and higher
ROIC. Key risks to our target price include any corporate event including delisting of MphasiS by
parent HP, and any resulting price uptick vs our target price.
Key risks to our optimistic outlook
Indian IT sector’s revenue growth – and therefore sector performance – depends largely on
the macro environment in western economies, given significant revenues coming from the
US and Europe.
Key risk to our optimistic outlook
Any further deterioration in the macro environment in western economies, especially in the US
and Europe.
Any sharp INR appreciation vs the USD. We estimate a 7% appreciation on the average INR
vs the USD in FY10-13F. From the current spot rate of Rs45.6, our average estimate for
FY13F indicates 3.5% appreciation. Besides INR appreciation vs the USD, any depreciation in
other foreign currencies (especially GBP, EUR and AUD) vs the USD affects the USD growth
of Indian IT companies given that a material proportion of their export revenues is
denominated in non-USD currencies.
Austerity and resulting protectionism measures in western economies can affect Indian IT
sector growth given the resulting negative impact on volume growth and/or higher cost of
delivery.
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