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UBS Investment Research
Indian IT Services
2011: a year of tough competition
Secular offshoring trend has increased competition for Indian vendors
India now comprises 21% of global IT services outsourcing and this secular trend
has led many global vendors and client captives to India; accounting for almost
40% of exports from India. We believe competition will intensify as the next wave
of India-based IT outsourcing begins to build up.
Lower-margin vendors have gained critical mass
Over the past few years, lower-margin vendors such as Cognizant and HCL
Technologies (HCL Tech) have gained critical mass (US$3-4bn in revenue). We
believe this will exert greater competitive pressure on Indian vendors, and manifest
itself in the form of investments in sales and marketing, and more supply pressure.
Vendor differentiation likely by market share gains
We believe some vendors will be able to withstand intensifying competition better
than others, and gain market share with minimal margin erosion. We believe Tata
Consultancy Services (TCS) and Infosys Technologies (Infosys) will fare better as
strong brand equity, execution, and better margin resilience will help consolidate
their market positions. Wipro is restructuring and we believe it will take longer for
it to consolidate market share. We expect most mid-cap vendors to suffer due to
lack of scale and margin resilience.
UBS view: cautious, pick winners where valuations are not rich
Our top pick is Infosys. We upgrade the stock from Neutral to Buy, and introduce a
Short-term Buy rating, triggered by FY12 guidance. We maintain our Neutral
rating on TCS on valuation concerns, and our Sell ratings on Wipro and HCL
Tech. We are turning more cautious on mid caps and downgrade MphasiS from
Buy to Neutral, and lower our FY11/FY12/FY13 EPS estimates from
Rs55.43/59.77/70.85 to Rs40.53/42.29/46.72.
Executive summary
Offshoring 3.0 seems to have begun
In our report, Indian IT Services: Offshoring 3.0—realities of a changed world,
dated 30 October 2009, we had discussed the beginning of the third wave for
India-based offshore IT service providers. Following the strong recovery in 2010,
we think the Indian IT services industry is indeed in the early stages of the third
wave of offshoring and a multi-year cycle of revenue growth. Demand recovery
has been better than we had expected in early 2010, and we forecast strong mid- to
high twenties growth in dollar revenue for large Indian vendors in FY12.
Global vendors, captives are 40% of Indian IT
India now accounts for nearly 40% of applications outsourcing and 21% of
global IT services outsourcing. Cost effectiveness and demographic advantages
have favoured India-based outsourcing, and global vendors and foreign client
captives (a business unit functioning in an offshore location) have moved to
India, in line with this trend. Global vendors and captives now account for
nearly 40% of IT services exports from India. Large global vendors such as IBM
and Accenture have 20-30% of their total workforce in India, which is the fastest
growing location for most global vendors.
Lower-margin vendors now have size to compete effectively
Vendors such as Cognizant and HCL Tech have gained significant market share
over the past few years. We believe this is due to their lower margin profiles,
which have helped them to invest more in client-facing activities such as sales &
marketing and wages to attract talented professionals. We believe these vendors
have gained critical mass (US$3-4bn in revenue), which will help them compete
more effectively against larger vendors. While we do not expect this to translate
to immediate pricing pressure, we do expect it to lead to investment in sales &
marketing as well as higher supply costs from other large vendors.
Supply pressures are unlikely to let up
While the demand recovery has been stronger than expected, so has supply pressure.
In our report (cited above), we had noted that revenue growth would be accompanied
by increased competition and higher operating investments, which could lower
margins and earnings growth. We think large Indian vendors are likely to end FY11
with 100-300bp of EBITDA margin erosion, a steeper decline than the 50-180bp we
estimated in early 2010. Our channel checks indicate average wage hikes of 15% or
more in 2011, which could add pressure on operating margins.
Cautious on Indian IT in 2011; some stocks have upside potential
and downside protection
We think gaining market share will become difficult, because of increased
competition in offshore delivery. While we are cautious on the overall sector, we
expect some vendors to grow faster disproportionately due to their ability to
withstand competitive pressure. We believe such vendors will also be defensive
stocks in a volatile market, with significant downside protection at current levels
Investment ideas
Pick vendors that can withstand competition
We expect competition in India-based IT services delivery to intensify over the
next few years, from both domestic and global vendors. We think this will
become more of a scale-play with mid-sized vendors continuing to struggle to
grow revenue in line with the larger vendors. We expect greater differentiation
to emerge among the top five vendors, primarily in terms of market strategy,
growth strategy and margin profiles. In this scenario, we would prefer vendors
that can withstand competition and continue to gain market share faster than
peers. In the following table, we summarise the primary strengths and
weaknesses of companies under our coverage in terms of market position and
growth profiles:
Table 1: Analysis of competitive strengths and weaknesses
Company Strengths Weaknesses
TCS *Scale-player in key vertical segments such as financial services and telecom
*Strong technology focus helps identify market trends earlier, eg, platform-based
BPO offerings, cloud-based SME offerings
*Successful M&A strategy to help strengthen vertical industry focus, eg, eServe
*Stronger-than-expected margin resilience
*45% exposure to financial services leaves revenue more vulnerable
to economic shocks
*Relative sluggishness in enterprise solutions
Infosys *Strong brand equity as a world-class offshore services provider
*Leadership position in enterprise solutions and hi-tech/manufacturing
*Strong margin profile
*Recent workforce realignment has led to high attrition and related
fulfilment issues
*Reluctance to use inorganic growth initiatives
Wipro *Well diversified in terms of verticals, services and markets
*Strong presence in infrastructure services
*Significant emerging market presence
*Lack of strong presence in financial services
*Higher vulnerability to employee costs due to high employee
utilisation rate
*Lower margin resilience
HCL Tech *Strong presence in infrastructure services
*Axon acquisition has helped bolster capabilities in enterprise solutions
*Lack of strong presence in financial services
*BPO is loss making, and likely to take a few quarters to turn around
*Low margin resilience
MphasiS *HP holds a 61% stake in MphasiS, helping it position itself better than other
mid-cap vendors
*Better positioned than other mid-caps to attract talent
*Lack of revenue visibility following the recent revenue decline from
the HP channel
*Lack of negotiating power with HP
Patni *Strong capabilities in insurance and manufacturing
*Company on the verge of a turnaround post-restructuring
*Recent acquisition by iGate Corp could lead to the departure of
senior management
*Integration process with iGate could dampen near-term outlook
Mahindra
Satyam
*Reasonably large enterprise solutions practice
*Continued deal wins in emerging markets
*Legal liabilities on account of fraud by founder and ex-chairman
Ramalinga Raju
*Restructuring likely to take longer than expected
Tech
Mahindra
*Capabilities in the telecom vertical
*Strong contender for telecom deals in emerging markets
*Lack of revenue diversification
*BT, the largest client, continues downsizing
Source: Company data, UBS
Stock picks
We think Infosys and TCS are likely winners
Given the issues of revenue growth and margin resilience that most mid-cap
vendors have been facing for the past several years, we believe larger vendors
such as Infosys, TCS, Wipro and HCL Tech are better placed to gain market
share than their smaller peers. Among our India IT universe, we believe TCS
and Infosys are best positioned to gain market share faster than peers. Even
though we expect these vendors’ margins to narrow, we think their resilience
will be superior to Wipro and HCL Tech’s given their stronger delivery model,
wider employee pyramids and greater scale of operations.
We also like Cognizant, listed in the US and covered by our US analyst Jason
Kupferberg, and believe its stated policy of maintaining margins at a moderate
19-20% allows for greater growth flexibility and market share gains.
Infosys is our top pick, near-term catalyst likely
We upgrade our rating for Infosys from Neutral to Buy and raise our price target
from Rs3,175 to Rs3,700. We believe the stock is now more attractively valued
after its 12.7% correction from a high of Rs3,481 in January 2011. We introduce
a Short-term Buy rating on expectations of strong initial guidance for FY12 in
April. The stock is trading at a 6.0% discount to TCS, and we believe the
valuation gap will narrow, as we expect stronger EPS growth in FY12. Infosys
is our top pick in our coverage universe.
We maintain our Neutral rating on TCS, which was our top pick from October-
November 2009. The company has since beaten our most bullish estimates. It
also outperformed the local benchmarks by an average of 38.5%, and Infosys by
30.9% in 2010. While we continue to believe TCS will maintain its market
dominance and sustain long-term growth, we maintain our Neutral rating as we
think it is fairly valued at the current level.
We maintain our Sell rating on Wipro. We think its revenue growth is likely to
accelerate in the near term, following its restructuring and the recent change in
management. However, we believe this is fully reflected in the current valuation,
with the stock trading at an 11.3% discount to Infosys.
We also maintain our Sell rating on HCL Tech, which we believe is richly
valued, trading at a 21.9% discount to Infosys compared with its historical
average of 28%. The company has guided for greater margin focus over the next
few quarters, which we believe is already reflected in its share price.
Nonetheless, we remain cautious, given our concern about a potential trade-off
between margins and revenue growth.
Turning incrementally cautious on mid-cap stocks
We are more cautious in our outlook for mid-sized Indian IT services vendors.
— We maintain our Buy rating on Patni and lower our price target from
Rs600.00 to Rs530.00 to factor in our more moderate margin assumptions.
— We downgrade MphasiS from Buy to Neutral and lower our price target
from Rs900.00 to Rs500.00, because of the lack of revenue visibility
— We maintain our Sell rating on Mahindra Satyam on our view that its
turnaround will take longer than expected.
— We maintain our Neutral rating on Tech Mahindra, as we believe a
merger with Mahindra Satyam will be more favourable for Tech
Mahindra stakeholders.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
UBS Investment Research
Indian IT Services
2011: a year of tough competition
Secular offshoring trend has increased competition for Indian vendors
India now comprises 21% of global IT services outsourcing and this secular trend
has led many global vendors and client captives to India; accounting for almost
40% of exports from India. We believe competition will intensify as the next wave
of India-based IT outsourcing begins to build up.
Lower-margin vendors have gained critical mass
Over the past few years, lower-margin vendors such as Cognizant and HCL
Technologies (HCL Tech) have gained critical mass (US$3-4bn in revenue). We
believe this will exert greater competitive pressure on Indian vendors, and manifest
itself in the form of investments in sales and marketing, and more supply pressure.
Vendor differentiation likely by market share gains
We believe some vendors will be able to withstand intensifying competition better
than others, and gain market share with minimal margin erosion. We believe Tata
Consultancy Services (TCS) and Infosys Technologies (Infosys) will fare better as
strong brand equity, execution, and better margin resilience will help consolidate
their market positions. Wipro is restructuring and we believe it will take longer for
it to consolidate market share. We expect most mid-cap vendors to suffer due to
lack of scale and margin resilience.
UBS view: cautious, pick winners where valuations are not rich
Our top pick is Infosys. We upgrade the stock from Neutral to Buy, and introduce a
Short-term Buy rating, triggered by FY12 guidance. We maintain our Neutral
rating on TCS on valuation concerns, and our Sell ratings on Wipro and HCL
Tech. We are turning more cautious on mid caps and downgrade MphasiS from
Buy to Neutral, and lower our FY11/FY12/FY13 EPS estimates from
Rs55.43/59.77/70.85 to Rs40.53/42.29/46.72.
Executive summary
Offshoring 3.0 seems to have begun
In our report, Indian IT Services: Offshoring 3.0—realities of a changed world,
dated 30 October 2009, we had discussed the beginning of the third wave for
India-based offshore IT service providers. Following the strong recovery in 2010,
we think the Indian IT services industry is indeed in the early stages of the third
wave of offshoring and a multi-year cycle of revenue growth. Demand recovery
has been better than we had expected in early 2010, and we forecast strong mid- to
high twenties growth in dollar revenue for large Indian vendors in FY12.
Global vendors, captives are 40% of Indian IT
India now accounts for nearly 40% of applications outsourcing and 21% of
global IT services outsourcing. Cost effectiveness and demographic advantages
have favoured India-based outsourcing, and global vendors and foreign client
captives (a business unit functioning in an offshore location) have moved to
India, in line with this trend. Global vendors and captives now account for
nearly 40% of IT services exports from India. Large global vendors such as IBM
and Accenture have 20-30% of their total workforce in India, which is the fastest
growing location for most global vendors.
Lower-margin vendors now have size to compete effectively
Vendors such as Cognizant and HCL Tech have gained significant market share
over the past few years. We believe this is due to their lower margin profiles,
which have helped them to invest more in client-facing activities such as sales &
marketing and wages to attract talented professionals. We believe these vendors
have gained critical mass (US$3-4bn in revenue), which will help them compete
more effectively against larger vendors. While we do not expect this to translate
to immediate pricing pressure, we do expect it to lead to investment in sales &
marketing as well as higher supply costs from other large vendors.
Supply pressures are unlikely to let up
While the demand recovery has been stronger than expected, so has supply pressure.
In our report (cited above), we had noted that revenue growth would be accompanied
by increased competition and higher operating investments, which could lower
margins and earnings growth. We think large Indian vendors are likely to end FY11
with 100-300bp of EBITDA margin erosion, a steeper decline than the 50-180bp we
estimated in early 2010. Our channel checks indicate average wage hikes of 15% or
more in 2011, which could add pressure on operating margins.
Cautious on Indian IT in 2011; some stocks have upside potential
and downside protection
We think gaining market share will become difficult, because of increased
competition in offshore delivery. While we are cautious on the overall sector, we
expect some vendors to grow faster disproportionately due to their ability to
withstand competitive pressure. We believe such vendors will also be defensive
stocks in a volatile market, with significant downside protection at current levels
Investment ideas
Pick vendors that can withstand competition
We expect competition in India-based IT services delivery to intensify over the
next few years, from both domestic and global vendors. We think this will
become more of a scale-play with mid-sized vendors continuing to struggle to
grow revenue in line with the larger vendors. We expect greater differentiation
to emerge among the top five vendors, primarily in terms of market strategy,
growth strategy and margin profiles. In this scenario, we would prefer vendors
that can withstand competition and continue to gain market share faster than
peers. In the following table, we summarise the primary strengths and
weaknesses of companies under our coverage in terms of market position and
growth profiles:
Table 1: Analysis of competitive strengths and weaknesses
Company Strengths Weaknesses
TCS *Scale-player in key vertical segments such as financial services and telecom
*Strong technology focus helps identify market trends earlier, eg, platform-based
BPO offerings, cloud-based SME offerings
*Successful M&A strategy to help strengthen vertical industry focus, eg, eServe
*Stronger-than-expected margin resilience
*45% exposure to financial services leaves revenue more vulnerable
to economic shocks
*Relative sluggishness in enterprise solutions
Infosys *Strong brand equity as a world-class offshore services provider
*Leadership position in enterprise solutions and hi-tech/manufacturing
*Strong margin profile
*Recent workforce realignment has led to high attrition and related
fulfilment issues
*Reluctance to use inorganic growth initiatives
Wipro *Well diversified in terms of verticals, services and markets
*Strong presence in infrastructure services
*Significant emerging market presence
*Lack of strong presence in financial services
*Higher vulnerability to employee costs due to high employee
utilisation rate
*Lower margin resilience
HCL Tech *Strong presence in infrastructure services
*Axon acquisition has helped bolster capabilities in enterprise solutions
*Lack of strong presence in financial services
*BPO is loss making, and likely to take a few quarters to turn around
*Low margin resilience
MphasiS *HP holds a 61% stake in MphasiS, helping it position itself better than other
mid-cap vendors
*Better positioned than other mid-caps to attract talent
*Lack of revenue visibility following the recent revenue decline from
the HP channel
*Lack of negotiating power with HP
Patni *Strong capabilities in insurance and manufacturing
*Company on the verge of a turnaround post-restructuring
*Recent acquisition by iGate Corp could lead to the departure of
senior management
*Integration process with iGate could dampen near-term outlook
Mahindra
Satyam
*Reasonably large enterprise solutions practice
*Continued deal wins in emerging markets
*Legal liabilities on account of fraud by founder and ex-chairman
Ramalinga Raju
*Restructuring likely to take longer than expected
Tech
Mahindra
*Capabilities in the telecom vertical
*Strong contender for telecom deals in emerging markets
*Lack of revenue diversification
*BT, the largest client, continues downsizing
Source: Company data, UBS
Stock picks
We think Infosys and TCS are likely winners
Given the issues of revenue growth and margin resilience that most mid-cap
vendors have been facing for the past several years, we believe larger vendors
such as Infosys, TCS, Wipro and HCL Tech are better placed to gain market
share than their smaller peers. Among our India IT universe, we believe TCS
and Infosys are best positioned to gain market share faster than peers. Even
though we expect these vendors’ margins to narrow, we think their resilience
will be superior to Wipro and HCL Tech’s given their stronger delivery model,
wider employee pyramids and greater scale of operations.
We also like Cognizant, listed in the US and covered by our US analyst Jason
Kupferberg, and believe its stated policy of maintaining margins at a moderate
19-20% allows for greater growth flexibility and market share gains.
Infosys is our top pick, near-term catalyst likely
We upgrade our rating for Infosys from Neutral to Buy and raise our price target
from Rs3,175 to Rs3,700. We believe the stock is now more attractively valued
after its 12.7% correction from a high of Rs3,481 in January 2011. We introduce
a Short-term Buy rating on expectations of strong initial guidance for FY12 in
April. The stock is trading at a 6.0% discount to TCS, and we believe the
valuation gap will narrow, as we expect stronger EPS growth in FY12. Infosys
is our top pick in our coverage universe.
We maintain our Neutral rating on TCS, which was our top pick from October-
November 2009. The company has since beaten our most bullish estimates. It
also outperformed the local benchmarks by an average of 38.5%, and Infosys by
30.9% in 2010. While we continue to believe TCS will maintain its market
dominance and sustain long-term growth, we maintain our Neutral rating as we
think it is fairly valued at the current level.
We maintain our Sell rating on Wipro. We think its revenue growth is likely to
accelerate in the near term, following its restructuring and the recent change in
management. However, we believe this is fully reflected in the current valuation,
with the stock trading at an 11.3% discount to Infosys.
We also maintain our Sell rating on HCL Tech, which we believe is richly
valued, trading at a 21.9% discount to Infosys compared with its historical
average of 28%. The company has guided for greater margin focus over the next
few quarters, which we believe is already reflected in its share price.
Nonetheless, we remain cautious, given our concern about a potential trade-off
between margins and revenue growth.
Turning incrementally cautious on mid-cap stocks
We are more cautious in our outlook for mid-sized Indian IT services vendors.
— We maintain our Buy rating on Patni and lower our price target from
Rs600.00 to Rs530.00 to factor in our more moderate margin assumptions.
— We downgrade MphasiS from Buy to Neutral and lower our price target
from Rs900.00 to Rs500.00, because of the lack of revenue visibility
— We maintain our Sell rating on Mahindra Satyam on our view that its
turnaround will take longer than expected.
— We maintain our Neutral rating on Tech Mahindra, as we believe a
merger with Mahindra Satyam will be more favourable for Tech
Mahindra stakeholders.
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