Please Share:: 
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Sector downgrade
We are downgrading our sector recommendation for Indian IT from
Neutral to Underweight as we watch the margin of safety in Indian IT
stocks recede. We see three extant islands of optimism being tested in
Indian techs in coming months. 1) 20%+ growth is achievable in
FY13/14 for Tier-1 vendors. 2) Visa issues are unlikely to alter business
prospects. 3) Valuations of Tier-1 techs are not at risk. We expect the
upcoming months to be a downward inflexion point for trends in all three
parameters driving stock prices down, though June quarter results are
unlikely to show any material proof points. Indian IT holds little promise
of sustainable absolute returns hereon. We are downgrading TCS and
Infosys to Underperform and have no positive ratings in the sector now.
Three questions before Indian IT
q Is 20%+ growth achievable in FY13/14? While demand trajectory is good for now,
it has flat-lined after the surge last year, posing risks to street revenue forecasts
for future years. Also, CLSA’s strategist Russell Napier’s forecast of a rise in US
treasury yields to potentially deflationary levels could impact growth prospects.
q How much is the visa issue hurting? Newsflow on the visa front continues to be
negative across countries with rejection rates in US currently running at almost
40%, up from 5%, 18 months back. We see the visa issue fundamentally altering
the business model for Indian techs with its operational (inability to staff projects
on time) as well as commercial (higher visa/subcontracting costs) impact.
q Can valuations of Tier-1 techs sustain? Valuations of Tier-1 techs need to contend
with lower (mid to high teens) revenue/EPS Cagr outlook, as well as the challenges
from business transformation that lie ahead. The risk of a potential IT spending
slowdown further raises the spectre of valuation compression.
Where is the disconnect with bullish management commentary?
q Bullish management commentary is comforting, but perhaps not actionable given
the already high street expectations (20%+ growth for tier-1 techs over next few
years) and the history of the sector’s major moves (2001, 2003 and 2007), where
company talk remained positive well into the demand flux.
q Moreover, while confidence on near-term demand remains strong across vendors,
commentary on FY12 growth achievement has gradually shifted from the confident
certainty earlier this year to hopes of a 2H pick-up.
q Past trends indicate that expectations of back-ended growth have seldom borne
fruit and have been de-railed due to a range of unanticipated causes. We believe
that the current macro overhang could likely cause an encore later this year.
See absolute downsides in all stocks
q As our checks point to moderating growth, within a more challenging business
(visas + need for non-linearity) and cost (wage hikes + local hiring) dynamic, we
see absolute downsides for tech stocks, especially over the short to medium term.
q While a major upgrade of the current earnings trajectory is a necessary trigger for
stock performance, even minor EPS downgrades could have a disproportionate
impact on valuations and stock price. As such, investment in IT stocks has an
unfavourable risk-reward equation for now.
q We now have a negative rating on all stocks in our Indian IT coverage list.
Stock-specific issues
q TCS: Within the sector, company credentials remain very strong but the stock
needs to contend with high expectations and over-ownership.
q Infosys: FY12 hopes have moderated but FY13 expectations remain elevated.
Internal issues seem sorted but an unfavourable macro will likely play spoilsport.
q Wipro: Achievement of street expectations is contingent on a 2HFY12 pick-up by
which time we expect demand environment to soften. Internal issues will take time
to sort out limiting financial performance c.f. peers.
q HCL Tech: Aggression in the market could drive industry-leading growth but at the
cost of margin impairment. High expectations leave little room for disappointment.
Expect revenue momentum to moderate ahead
Inflexion points in YY revenue trajectory have been important indicators of
near to medium term stock performance for Indian techs and we believe one
such is at hand right now. We believe YY revenue growth (on a quarterly
basis) has peaked for Indian Techs and a downtrend is likely. Unlike same
time last year, when there was a big surge in demand, demand has been
more normal this year with odd instances of some delays/deferrals. This flatlining of demand trajectory (good on an absolute basis but faces tough YY
comps) will limit revenue growth prospects for tier-1 Indian techs ahead.
Conversations with CIOs of select banks and third party deal advisors back
our thesis of good but flattish deal/pipeline trajectory. In our meeting last
week, the Infosys CEO mentioned that the number of deals at the moment is
lower than the Sep/Dec 2010 period. He also indicated that macro issues are
weighing on clients’ minds (though there had been no major
deferrals/cancellations till then) and reaction to any big event could be
sudden. CLSA Strategist Russell Napier believes that the macro situation will
only worsen from current levels.
In this backdrop, we do not see any significant improvement in the deal
trajectory for now. This precludes upsides to street revenue forecasts and we
fear that the bias could be on the downside. A cut in street revenue estimates
will likely be accompanied by impairment in stock valuations.
Indian techs are also parallely grappling with two other issues which will have
an important bearing on financials and consequently stock performance. Visa
problems, which were merely an irritant last year, are now forcing a big rethink in Indian Tech’s onsite staffing strategy. Also, the rising scale of
business has increased the urgency in non-linear initiatives and is pushing
Indian Techs companies out of their comfort zone.
Visa issues could fundamentally alter the business model
We have so far refrained from quantifying the risks of protectionism as
historically, Indian IT has always managed to find its way around protectionist
measures in US and other client markets. However select events are piling up
and we now see visa issue as a game changer for the Indian IT industry. Visa
policy/procedure in client markets (US, UK, Switzerland, Canada) is veering
towards greater oversight and imposition, especially over the past 12-18
months and impacting Indian techs. Visa rejection rates in US for Tier-1
Indian techs have reached a high of almost 40% from 5% just 18 months.
Our checks suggest that one of the Tier-1 IT companies has not received a
single B-1/L-1/H-1B visa for delivery personnel in the last 4.5 months. Figure
2 gives an overview of some of the changes being implemented on the visa
front in select countries.
Figure 2
Overview of changes/issues in visas in select client markets
Country Process Minimum wages
UK
• Tier 2 General category ( used by Indian Tech companies) is subject to a
quota of 20,700 (effective Apr 2011)
• The job must be advertised for 1 week or more before a work permit can be
issued for it
• Multi-step processes with total fees amounting to GBP8,500
For less than 1 year : GBP24,000
For more than 1 year :
GBP40,000
US
• Sharp jump in rejection rates from 5% to 40% over last 18 months
• ~100% hike in Visa processing fees from US$2,320 to US$4,545
• New recommendations to make advertising for the concerned positions for
H1-B visas compulsory
Canadian
• The Canadian employer will have to apply for approval of the job offer to a
foreign worker.
• The Canadian employer will have to advertise for that position.
• Approval will be granted only after the Immigration dept is satisfied that
"adequate" efforts have been made to recruit local talent
• For certain minutely specified software roles, pre-approval has been
granted
Software Developer - services :
US$50,000
Software products developer :
US$60,000
Switzerland
• Of the total quota of 12,000 permits, from FY11 3,500 have been reserved
for workers from the EU
• Of the remaining only 5,000 L-Permits for stay of up to 1 year, and 3,500
B-Permits for longer stay
From US$100,000 - 112,000
depending on length of stay
Source: CLSA Asia-Pacific Markets
Switzerland (5
th
largest export market for Indian IT) has introduced minimum
wage requirements in addition to quotas. UK has also increased the minimum
wages for visas greater than 12 months. Canada (was being explored as a
near-shore destination for US work) has also increased procedural hurdles
which is making visa procurement much tougher.
Impact points for Indian IT – Operational as well as Commercial
H-1B/L-1 visas remain core to Indian IT’s onsite-offshore business model and
procedural or regulatory hurdles here are bound to impact Indian Techs. With
over 90% of employees in US already on L-1/H-1B visas, stricter visa
procedures/regulations could force Indian Techs to hire more locals at a pace
faster than they are doing right now (voluntary attempts already in progress),
impacting margins and operational flexibility. Greater local hiring would not only
impact the cost structure adversely, it will also reduce flexibility in managing
onsite utilisation. Discussions with select Tier-1 companies indicate that onsite
utilisation will likely come down from mid 90s currently to mid 80s over the
next couple of years, impacting margins
Figure 3 gives a simplistic calculation of the cost differential between a local
employee and an Indian sent abroad on a visa. Note that we have assumed
similar wages for both (though we suspect the local hire will have to be paid
more as demand for such people increases). The key difference is that in
absence of any projects, the Indian employee is sent back to India where
wages are much lower. Also, unlike Indian employees, local hires are less
flexible in moving across different states in US for projects.
Another impact point is elevated sub-contracting costs. Inability to staff
projects due to visa rejections will force companies to look for subcontractors. Sub-contractors more expensive and will impact profitability. Visa
application expenses have also risen across countries (doubled in US) and
higher rejection rate does imply extra costs (though not very significant). An
operational impact of higher visa rejections is the strain it puts on the staffing
department. We fear loss of revenues driven by inability to staff projects.
Large lobby groups exist in favour of outsourcing, including Fortune 100/500
corporations who have actively outsourced. These lobbies favour benign visa
policies. However, the current economic/unemployment situation is developed
countries is conducive for stricter visa processes. Indian techs will explore
ways around this visa conundrum with solutions ranging from greater offshoring to near-shoring (Austria for Switzerland or Canada for US). However,
these will take time to mature and margin impact seems unavoidable.
Non-linear growth demands business model changes
A linear growth plan for companies already past the 100,000 people mark,
with some having 200,000 in sights, is not tenable beyond a few years. After
all, 20% annual growth implies a doubling every four years. Hence, new
modes of doing business and investments in non-linear opportunities have
acquired a sense of urgency. Expansion into non-linear offerings (solutions,
platforms and cloud services) will address the twin objectives of expanding
market share and controlling wage costs. However, this puts Indian IT
companies in unfamiliar territory. Not only does this carry investment costs
(will involve some compromise on margins and asset intensity) but it also
impairs the normal predictability of the business. In our view, this deviation in
business model will have a bearing on stock performance in the medium term.
The profile of people staffed on such projects is also much different from the
normal business. E.g. The average experience of people who developed TCS’
4 BPO platforms was 8-9 years, much higher than the 3-year average
prevalent across the company. In this regard, a frequent check of the
demand-supply balance in manpower becomes necessary. Industry watchers,
including us, have at times erred by only looking at overall demand-supply
of manpower, but the demand for experienced manpower has assumed
greater significance given the shifting priorities of Indian Techs.
Experience is already in short supply
A 15% YY growth in Indian IT services exports in FY12 and FY13 will demand
over 165,000 additional employees in the “3+ years’ experience” range. This
manpower requirement will have to be almost entirely fulfilled by employees
who joined the industry in FY09/10, plus some hires from other industries.
The bad news is that industry has not hired enough in the last two years to
meet future needs. The modest hiring in FY09/10 will likely skew the
manpower demand-supply dynamics in FY12 and especially in FY13, putting
an upward pressure on wages. Note that incremental manpower is the correct
metric to see the demand-supply dynamics as high utilisation levels in the
industry implies existing employees are already staffed on projects. Another
trend which needs to be watched is the increase in average experience levels
across the industry, as projects become larger and more complicated.
Figures 5 & 6 represent our simulation of the incremental staff required to
service the demand in FY12/13. We must point out that this is an industry
based demand supply model.
Valuations of Tier-1 techs are at risk
PE multiples are slaves of earnings growth. Yet, they are also an opinion.
Perceptions of change in business model, weakening topline momentum
and/or sustained margin erosion harm multiples, as they did in 2007-08.
Through the last decade, valuations of Indian techs have slowly contracted
from 25-26x 1-year forward earnings in 2006-07 to 20-21x now. In our view,
the lingering overhang from macro issues will likely lead to a downward reset
in future revenue growth expectations. Further, the accompanying changes in
the business model (more investments in non-linearity + visa issues forcing
greater local hiring) could impact margin profile of the companies. A lower
EPS Cagr should follow leading to further contraction in valuation of Tier-1s.
What PE multiple should Tier-1 Indian techs trade at?
PE multiples for Indian IT stocks have expanded over the past two years.
However, we expect contraction ahead and believe this is structural, and a part
of a gradual process of recognition of lower EPS Cagrs ahead. EPS Cagrs for the
next three years for Tier-1 Indian IT should settle in the 15-17% range. In such
an environment, high ROEs and good free cash-flow profile notwithstanding, it is
extremely difficult to make a case for PE multiples above the mid to high-teens.
PE multiples in Indian IT tend to track near-term revenue growth prospects,
which we expect to be in the mid to high teens.
A theoretical exercise to determine Infosys’ PE multiple indicates a target
multiple of close to 17-18x. However, note that most Indian companies are now
looking at acquisitions for growth and any big acquisition could alter the return
as well as payout ratios, thus impacting the theoretical target PE. For example,
we have seen cash-flow situations change dramatically at HCL Tech as large
acquisitions were consummated.
Figure 7
Theoretical PE multiple assuming only organic growth
(%) Infosys
Payout ratio 45
High growth rate 15
Cost of equity 13.1
Payout ratio (n) 75
Stable growth rate 7.5
ROE 27
ROE, steady state 30
Number of years of high growth 4
Theoretical PE (x) 17.3
Source: CLSA Asia-Pacific Markets
See absolute downsides in all stocks
Looking at the arguments above, our view on the sector is bearish compared
to the neutral view a few months back. While we recognise the good demand
environment, absolute upsides in stocks demand greater heights to be
reached in earnings surprises, which we find elusive. As our checks point to
continuing but moderating growth within a more challenging business (visas
+ need for non-linear growth) and cost (offshore wage hikes + greater local
hiring in client locations) dynamic, we see absolute downsides for tech stocks,
especially over the short to medium term.
Prospects of lower growth will likely drive valuation de-rating and leading
Indian IT stocks seem unlikely to yield any return over the next 9-12 months.
Short-term variations in this overall return scenario are possible, especially
given triggers in the form of news flow, quarterly results and other near-term
factors (outperformance versus street expectations in a quarter, for example),
but sustainable stock returns are likely to remain elusive. Overall market
sentiment and currency swings could also play an important role in shortterm stock movements, especially given the perceived defensive nature of
Indian techs. This does not change the imperatives before Indian techs:
growth will come by but scale of the companies and a worsening macro will
make it somewhat harder; margins are more likely to head down (as visa
issues force greater local hiring and wage hikes in India force greater
investments in non-linear initiatives) than up. This drives our negative bias
across the sector overall.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Sector downgrade
We are downgrading our sector recommendation for Indian IT from
Neutral to Underweight as we watch the margin of safety in Indian IT
stocks recede. We see three extant islands of optimism being tested in
Indian techs in coming months. 1) 20%+ growth is achievable in
FY13/14 for Tier-1 vendors. 2) Visa issues are unlikely to alter business
prospects. 3) Valuations of Tier-1 techs are not at risk. We expect the
upcoming months to be a downward inflexion point for trends in all three
parameters driving stock prices down, though June quarter results are
unlikely to show any material proof points. Indian IT holds little promise
of sustainable absolute returns hereon. We are downgrading TCS and
Infosys to Underperform and have no positive ratings in the sector now.
Three questions before Indian IT
q Is 20%+ growth achievable in FY13/14? While demand trajectory is good for now,
it has flat-lined after the surge last year, posing risks to street revenue forecasts
for future years. Also, CLSA’s strategist Russell Napier’s forecast of a rise in US
treasury yields to potentially deflationary levels could impact growth prospects.
q How much is the visa issue hurting? Newsflow on the visa front continues to be
negative across countries with rejection rates in US currently running at almost
40%, up from 5%, 18 months back. We see the visa issue fundamentally altering
the business model for Indian techs with its operational (inability to staff projects
on time) as well as commercial (higher visa/subcontracting costs) impact.
q Can valuations of Tier-1 techs sustain? Valuations of Tier-1 techs need to contend
with lower (mid to high teens) revenue/EPS Cagr outlook, as well as the challenges
from business transformation that lie ahead. The risk of a potential IT spending
slowdown further raises the spectre of valuation compression.
Where is the disconnect with bullish management commentary?
q Bullish management commentary is comforting, but perhaps not actionable given
the already high street expectations (20%+ growth for tier-1 techs over next few
years) and the history of the sector’s major moves (2001, 2003 and 2007), where
company talk remained positive well into the demand flux.
q Moreover, while confidence on near-term demand remains strong across vendors,
commentary on FY12 growth achievement has gradually shifted from the confident
certainty earlier this year to hopes of a 2H pick-up.
q Past trends indicate that expectations of back-ended growth have seldom borne
fruit and have been de-railed due to a range of unanticipated causes. We believe
that the current macro overhang could likely cause an encore later this year.
See absolute downsides in all stocks
q As our checks point to moderating growth, within a more challenging business
(visas + need for non-linearity) and cost (wage hikes + local hiring) dynamic, we
see absolute downsides for tech stocks, especially over the short to medium term.
q While a major upgrade of the current earnings trajectory is a necessary trigger for
stock performance, even minor EPS downgrades could have a disproportionate
impact on valuations and stock price. As such, investment in IT stocks has an
unfavourable risk-reward equation for now.
q We now have a negative rating on all stocks in our Indian IT coverage list.
Stock-specific issues
q TCS: Within the sector, company credentials remain very strong but the stock
needs to contend with high expectations and over-ownership.
q Infosys: FY12 hopes have moderated but FY13 expectations remain elevated.
Internal issues seem sorted but an unfavourable macro will likely play spoilsport.
q Wipro: Achievement of street expectations is contingent on a 2HFY12 pick-up by
which time we expect demand environment to soften. Internal issues will take time
to sort out limiting financial performance c.f. peers.
q HCL Tech: Aggression in the market could drive industry-leading growth but at the
cost of margin impairment. High expectations leave little room for disappointment.
Expect revenue momentum to moderate ahead
Inflexion points in YY revenue trajectory have been important indicators of
near to medium term stock performance for Indian techs and we believe one
such is at hand right now. We believe YY revenue growth (on a quarterly
basis) has peaked for Indian Techs and a downtrend is likely. Unlike same
time last year, when there was a big surge in demand, demand has been
more normal this year with odd instances of some delays/deferrals. This flatlining of demand trajectory (good on an absolute basis but faces tough YY
comps) will limit revenue growth prospects for tier-1 Indian techs ahead.
Conversations with CIOs of select banks and third party deal advisors back
our thesis of good but flattish deal/pipeline trajectory. In our meeting last
week, the Infosys CEO mentioned that the number of deals at the moment is
lower than the Sep/Dec 2010 period. He also indicated that macro issues are
weighing on clients’ minds (though there had been no major
deferrals/cancellations till then) and reaction to any big event could be
sudden. CLSA Strategist Russell Napier believes that the macro situation will
only worsen from current levels.
In this backdrop, we do not see any significant improvement in the deal
trajectory for now. This precludes upsides to street revenue forecasts and we
fear that the bias could be on the downside. A cut in street revenue estimates
will likely be accompanied by impairment in stock valuations.
Indian techs are also parallely grappling with two other issues which will have
an important bearing on financials and consequently stock performance. Visa
problems, which were merely an irritant last year, are now forcing a big rethink in Indian Tech’s onsite staffing strategy. Also, the rising scale of
business has increased the urgency in non-linear initiatives and is pushing
Indian Techs companies out of their comfort zone.
Visa issues could fundamentally alter the business model
We have so far refrained from quantifying the risks of protectionism as
historically, Indian IT has always managed to find its way around protectionist
measures in US and other client markets. However select events are piling up
and we now see visa issue as a game changer for the Indian IT industry. Visa
policy/procedure in client markets (US, UK, Switzerland, Canada) is veering
towards greater oversight and imposition, especially over the past 12-18
months and impacting Indian techs. Visa rejection rates in US for Tier-1
Indian techs have reached a high of almost 40% from 5% just 18 months.
Our checks suggest that one of the Tier-1 IT companies has not received a
single B-1/L-1/H-1B visa for delivery personnel in the last 4.5 months. Figure
2 gives an overview of some of the changes being implemented on the visa
front in select countries.
Figure 2
Overview of changes/issues in visas in select client markets
Country Process Minimum wages
UK
• Tier 2 General category ( used by Indian Tech companies) is subject to a
quota of 20,700 (effective Apr 2011)
• The job must be advertised for 1 week or more before a work permit can be
issued for it
• Multi-step processes with total fees amounting to GBP8,500
For less than 1 year : GBP24,000
For more than 1 year :
GBP40,000
US
• Sharp jump in rejection rates from 5% to 40% over last 18 months
• ~100% hike in Visa processing fees from US$2,320 to US$4,545
• New recommendations to make advertising for the concerned positions for
H1-B visas compulsory
Canadian
• The Canadian employer will have to apply for approval of the job offer to a
foreign worker.
• The Canadian employer will have to advertise for that position.
• Approval will be granted only after the Immigration dept is satisfied that
"adequate" efforts have been made to recruit local talent
• For certain minutely specified software roles, pre-approval has been
granted
Software Developer - services :
US$50,000
Software products developer :
US$60,000
Switzerland
• Of the total quota of 12,000 permits, from FY11 3,500 have been reserved
for workers from the EU
• Of the remaining only 5,000 L-Permits for stay of up to 1 year, and 3,500
B-Permits for longer stay
From US$100,000 - 112,000
depending on length of stay
Source: CLSA Asia-Pacific Markets
Switzerland (5
th
largest export market for Indian IT) has introduced minimum
wage requirements in addition to quotas. UK has also increased the minimum
wages for visas greater than 12 months. Canada (was being explored as a
near-shore destination for US work) has also increased procedural hurdles
which is making visa procurement much tougher.
Impact points for Indian IT – Operational as well as Commercial
H-1B/L-1 visas remain core to Indian IT’s onsite-offshore business model and
procedural or regulatory hurdles here are bound to impact Indian Techs. With
over 90% of employees in US already on L-1/H-1B visas, stricter visa
procedures/regulations could force Indian Techs to hire more locals at a pace
faster than they are doing right now (voluntary attempts already in progress),
impacting margins and operational flexibility. Greater local hiring would not only
impact the cost structure adversely, it will also reduce flexibility in managing
onsite utilisation. Discussions with select Tier-1 companies indicate that onsite
utilisation will likely come down from mid 90s currently to mid 80s over the
next couple of years, impacting margins
Figure 3 gives a simplistic calculation of the cost differential between a local
employee and an Indian sent abroad on a visa. Note that we have assumed
similar wages for both (though we suspect the local hire will have to be paid
more as demand for such people increases). The key difference is that in
absence of any projects, the Indian employee is sent back to India where
wages are much lower. Also, unlike Indian employees, local hires are less
flexible in moving across different states in US for projects.
Another impact point is elevated sub-contracting costs. Inability to staff
projects due to visa rejections will force companies to look for subcontractors. Sub-contractors more expensive and will impact profitability. Visa
application expenses have also risen across countries (doubled in US) and
higher rejection rate does imply extra costs (though not very significant). An
operational impact of higher visa rejections is the strain it puts on the staffing
department. We fear loss of revenues driven by inability to staff projects.
Large lobby groups exist in favour of outsourcing, including Fortune 100/500
corporations who have actively outsourced. These lobbies favour benign visa
policies. However, the current economic/unemployment situation is developed
countries is conducive for stricter visa processes. Indian techs will explore
ways around this visa conundrum with solutions ranging from greater offshoring to near-shoring (Austria for Switzerland or Canada for US). However,
these will take time to mature and margin impact seems unavoidable.
Non-linear growth demands business model changes
A linear growth plan for companies already past the 100,000 people mark,
with some having 200,000 in sights, is not tenable beyond a few years. After
all, 20% annual growth implies a doubling every four years. Hence, new
modes of doing business and investments in non-linear opportunities have
acquired a sense of urgency. Expansion into non-linear offerings (solutions,
platforms and cloud services) will address the twin objectives of expanding
market share and controlling wage costs. However, this puts Indian IT
companies in unfamiliar territory. Not only does this carry investment costs
(will involve some compromise on margins and asset intensity) but it also
impairs the normal predictability of the business. In our view, this deviation in
business model will have a bearing on stock performance in the medium term.
The profile of people staffed on such projects is also much different from the
normal business. E.g. The average experience of people who developed TCS’
4 BPO platforms was 8-9 years, much higher than the 3-year average
prevalent across the company. In this regard, a frequent check of the
demand-supply balance in manpower becomes necessary. Industry watchers,
including us, have at times erred by only looking at overall demand-supply
of manpower, but the demand for experienced manpower has assumed
greater significance given the shifting priorities of Indian Techs.
Experience is already in short supply
A 15% YY growth in Indian IT services exports in FY12 and FY13 will demand
over 165,000 additional employees in the “3+ years’ experience” range. This
manpower requirement will have to be almost entirely fulfilled by employees
who joined the industry in FY09/10, plus some hires from other industries.
The bad news is that industry has not hired enough in the last two years to
meet future needs. The modest hiring in FY09/10 will likely skew the
manpower demand-supply dynamics in FY12 and especially in FY13, putting
an upward pressure on wages. Note that incremental manpower is the correct
metric to see the demand-supply dynamics as high utilisation levels in the
industry implies existing employees are already staffed on projects. Another
trend which needs to be watched is the increase in average experience levels
across the industry, as projects become larger and more complicated.
Figures 5 & 6 represent our simulation of the incremental staff required to
service the demand in FY12/13. We must point out that this is an industry
based demand supply model.
Valuations of Tier-1 techs are at risk
PE multiples are slaves of earnings growth. Yet, they are also an opinion.
Perceptions of change in business model, weakening topline momentum
and/or sustained margin erosion harm multiples, as they did in 2007-08.
Through the last decade, valuations of Indian techs have slowly contracted
from 25-26x 1-year forward earnings in 2006-07 to 20-21x now. In our view,
the lingering overhang from macro issues will likely lead to a downward reset
in future revenue growth expectations. Further, the accompanying changes in
the business model (more investments in non-linearity + visa issues forcing
greater local hiring) could impact margin profile of the companies. A lower
EPS Cagr should follow leading to further contraction in valuation of Tier-1s.
What PE multiple should Tier-1 Indian techs trade at?
PE multiples for Indian IT stocks have expanded over the past two years.
However, we expect contraction ahead and believe this is structural, and a part
of a gradual process of recognition of lower EPS Cagrs ahead. EPS Cagrs for the
next three years for Tier-1 Indian IT should settle in the 15-17% range. In such
an environment, high ROEs and good free cash-flow profile notwithstanding, it is
extremely difficult to make a case for PE multiples above the mid to high-teens.
PE multiples in Indian IT tend to track near-term revenue growth prospects,
which we expect to be in the mid to high teens.
A theoretical exercise to determine Infosys’ PE multiple indicates a target
multiple of close to 17-18x. However, note that most Indian companies are now
looking at acquisitions for growth and any big acquisition could alter the return
as well as payout ratios, thus impacting the theoretical target PE. For example,
we have seen cash-flow situations change dramatically at HCL Tech as large
acquisitions were consummated.
Figure 7
Theoretical PE multiple assuming only organic growth
(%) Infosys
Payout ratio 45
High growth rate 15
Cost of equity 13.1
Payout ratio (n) 75
Stable growth rate 7.5
ROE 27
ROE, steady state 30
Number of years of high growth 4
Theoretical PE (x) 17.3
Source: CLSA Asia-Pacific Markets
See absolute downsides in all stocks
Looking at the arguments above, our view on the sector is bearish compared
to the neutral view a few months back. While we recognise the good demand
environment, absolute upsides in stocks demand greater heights to be
reached in earnings surprises, which we find elusive. As our checks point to
continuing but moderating growth within a more challenging business (visas
+ need for non-linear growth) and cost (offshore wage hikes + greater local
hiring in client locations) dynamic, we see absolute downsides for tech stocks,
especially over the short to medium term.
Prospects of lower growth will likely drive valuation de-rating and leading
Indian IT stocks seem unlikely to yield any return over the next 9-12 months.
Short-term variations in this overall return scenario are possible, especially
given triggers in the form of news flow, quarterly results and other near-term
factors (outperformance versus street expectations in a quarter, for example),
but sustainable stock returns are likely to remain elusive. Overall market
sentiment and currency swings could also play an important role in shortterm stock movements, especially given the perceived defensive nature of
Indian techs. This does not change the imperatives before Indian techs:
growth will come by but scale of the companies and a worsening macro will
make it somewhat harder; margins are more likely to head down (as visa
issues force greater local hiring and wage hikes in India force greater
investments in non-linear initiatives) than up. This drives our negative bias
across the sector overall.
No comments:
Post a Comment