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Tier-1 Indian IT stocks have fallen 18-21% in the last 1 month underperforming the
broader market by 5-8%. The sharp fall in the stocks and current valuation zone
has generated considerable investor interest, especially given the strong re-bound
in stocks seen post the 2008 slow-down. We continue to advise caution and remain
negative on the IT space. This note attempts to answer a few key investor issues.
#1: Will any of the Tier-1 techs be a significant sector outperformer?
The genesis of this issue likely lies in the significant outperformance of Infosys c.f.
peers in the 2008 slowdown and the divergence in stock performance in 1HCY11
(Infosys/Wipro performed poorly while TCS/HCL did better). However, we do not
see any such significant divergence ahead. Macro-headwinds will likely limit
financial/stock performance across the sector and we do not see any significant
valuation anomalies within the sector which warrant a correction.
Encore of 2008 stock performance divergence is unlikely
Two key factors drove Infosys’ outperformance c.f. peers in the 2008 slowdown:
better margin defence (Fig 3) and a lower hedge position which led to much lower
forex losses (Fig 4). Infosys’ FY10 EPS expectations were little changed through
2008 (Fig 6). However, we do not see any of the vendors in such a relatively
advantageous position currently. Post 2008, hedging policies of most vendors have
converged (two quarters net inflows) and there isn’t much difference in hedging
position relative to the revenue base. Revenue growth will also be likely impacted
across all vendors and potential near-term revenue outperformance of TCS (c.f.
peers) seems already captured in its premium valuations.
TCS/HCL’s outperformance seen in 1H11 is unlikely to sustain
Internal re-organisation at Infosys/Wipro was the key driver of financial
underperformance c.f. HCL/TCS impacting relative stock performance as well. While
this financial underperformance is unlikely to reverse immediately, it is not
incremental and captured in the earnings forecasts (Fig 7). Going ahead, we do not
expect Infosys/Wipro to surprise incrementally negatively relative to TCS/HCL.
Macro issues should impact top-line growth across vendors and we expect greater
#2: What valuation could the stocks bottom at?
The volatile macro-environment has expectedly increased uncertainty around FY13
growth prospects for Indian IT companies. This lack of clarity around earnings
makes calling an exact bottom of the stocks tough. That said, it is instructive to
look at the 2008 slowdown to see how absolute and relative (to broader market)
valuations behaved back then. In 2008, Infosys bottomed around 11-12xPE, TCS at
9-10xPE, Wipro at 7-8xPE and HCL at 6-7xPE even as the Indian broader market
bottomed at 10-11xPE.
In our view, this time around trough valuations will likely be higher than the
previous slowdown and a slightly higher premium to the Indian index. Given the
resilience showed by tech companies amid the 2008 crisis and the sharp re-bound
in stock prices post the Lehman crisis, investors will likely be inclined to give IT
stocks a greater benefit of doubt on the valuation front. As such, we expect the
bottom of valuations to be 10-15% higher than in 2008. This implies trough
valuations of 13-14x for Infosys/TCS and 9-10x for Wipro/HCL. However, unlike in
2008-09, stocks could stay at these trough valuations for a longer period of time.
#3: Will margin performance surprise positively a la FY09/10?
The key positive surprise from Indian Techs through the last slowdown was their
margin defence amid slowing volumes and pricing pressure. While currency
depreciation played a big role in this margin defence, improved operational prowess
(greater fixed price projects, improving utilisations, control on variable salaries)
also helped margins. However, we do not see this repeating through the next 12-18
months.
Figure 9
Expect margins to remain under pressure
Utilization
2008-09 2011-12
Utilization moved up from 69-
78% in Dec-07 to 79-85% by
Dec-09
However, lost out on volume
growth due to manpower
shortage.
Peak utilisations likely to be
lower than in 2008-09. Expect
vendors to keep a buffer for
any re-bund in growth.
Fixed price
projects
Fixed price projects share of
revenues increased from
30-40% in June-08 to around
40-50% by Dec-09. Helped
contain pricing pressure.
Limited manouevrability in
increasing fixed price project
proportion.
Pricing pressure will remain
impacting margins.
Local hiring No such pressure in 2008-09
Higher visa rejection rates and
tighter labour laws have caused
IT cos to ramp up local hiring.
Potential upward pressure on
onsite wage costs.
Non-linear
initiatives
Not as big a focus area.
Focus on non-linear solutions to
fight pricing pressures and
create differentiation.
Upfront investments in these
limits margin defence ability.
Currency
Rupee weakened by 25% from
Rs40 in Jan-08 to Rs50 by Mar-
09.
Low probability of such a
correction in 2011-12.
Source: CLSA Asia-Pacific Markets
While currency calls are always tough, 20% rupee depreciation (like in 2008) from
current levels seems a low probability event. Moreover, given the experience of
2009/10 where IT vendors lost out on volume growth due to lack of people, Tier-1
techs are unlikely to try and operate at completely optimal levels of utilisation (Fig
11). Consequently, cost of bench will likely be higher limiting margin upsides.
Ability to push deals into fixed price projects will also be limited c.f. 2008-09. Note
that most vendors increased proportion of revenues from fixed price projects (Fig
10) by 10-15ppt in the previous slowdown to manage pricing pressures. Also, the
need to invest currently is higher than anytime in the past: Greater local hiring to
manage visa rejection issues and increased investments in non-linear initiatives
(platforms/solutions) to manage pricing pressures.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Tier-1 Indian IT stocks have fallen 18-21% in the last 1 month underperforming the
broader market by 5-8%. The sharp fall in the stocks and current valuation zone
has generated considerable investor interest, especially given the strong re-bound
in stocks seen post the 2008 slow-down. We continue to advise caution and remain
negative on the IT space. This note attempts to answer a few key investor issues.
#1: Will any of the Tier-1 techs be a significant sector outperformer?
The genesis of this issue likely lies in the significant outperformance of Infosys c.f.
peers in the 2008 slowdown and the divergence in stock performance in 1HCY11
(Infosys/Wipro performed poorly while TCS/HCL did better). However, we do not
see any such significant divergence ahead. Macro-headwinds will likely limit
financial/stock performance across the sector and we do not see any significant
valuation anomalies within the sector which warrant a correction.
Encore of 2008 stock performance divergence is unlikely
Two key factors drove Infosys’ outperformance c.f. peers in the 2008 slowdown:
better margin defence (Fig 3) and a lower hedge position which led to much lower
forex losses (Fig 4). Infosys’ FY10 EPS expectations were little changed through
2008 (Fig 6). However, we do not see any of the vendors in such a relatively
advantageous position currently. Post 2008, hedging policies of most vendors have
converged (two quarters net inflows) and there isn’t much difference in hedging
position relative to the revenue base. Revenue growth will also be likely impacted
across all vendors and potential near-term revenue outperformance of TCS (c.f.
peers) seems already captured in its premium valuations.
TCS/HCL’s outperformance seen in 1H11 is unlikely to sustain
Internal re-organisation at Infosys/Wipro was the key driver of financial
underperformance c.f. HCL/TCS impacting relative stock performance as well. While
this financial underperformance is unlikely to reverse immediately, it is not
incremental and captured in the earnings forecasts (Fig 7). Going ahead, we do not
expect Infosys/Wipro to surprise incrementally negatively relative to TCS/HCL.
Macro issues should impact top-line growth across vendors and we expect greater
#2: What valuation could the stocks bottom at?
The volatile macro-environment has expectedly increased uncertainty around FY13
growth prospects for Indian IT companies. This lack of clarity around earnings
makes calling an exact bottom of the stocks tough. That said, it is instructive to
look at the 2008 slowdown to see how absolute and relative (to broader market)
valuations behaved back then. In 2008, Infosys bottomed around 11-12xPE, TCS at
9-10xPE, Wipro at 7-8xPE and HCL at 6-7xPE even as the Indian broader market
bottomed at 10-11xPE.
In our view, this time around trough valuations will likely be higher than the
previous slowdown and a slightly higher premium to the Indian index. Given the
resilience showed by tech companies amid the 2008 crisis and the sharp re-bound
in stock prices post the Lehman crisis, investors will likely be inclined to give IT
stocks a greater benefit of doubt on the valuation front. As such, we expect the
bottom of valuations to be 10-15% higher than in 2008. This implies trough
valuations of 13-14x for Infosys/TCS and 9-10x for Wipro/HCL. However, unlike in
2008-09, stocks could stay at these trough valuations for a longer period of time.
#3: Will margin performance surprise positively a la FY09/10?
The key positive surprise from Indian Techs through the last slowdown was their
margin defence amid slowing volumes and pricing pressure. While currency
depreciation played a big role in this margin defence, improved operational prowess
(greater fixed price projects, improving utilisations, control on variable salaries)
also helped margins. However, we do not see this repeating through the next 12-18
months.
Figure 9
Expect margins to remain under pressure
Utilization
2008-09 2011-12
Utilization moved up from 69-
78% in Dec-07 to 79-85% by
Dec-09
However, lost out on volume
growth due to manpower
shortage.
Peak utilisations likely to be
lower than in 2008-09. Expect
vendors to keep a buffer for
any re-bund in growth.
Fixed price
projects
Fixed price projects share of
revenues increased from
30-40% in June-08 to around
40-50% by Dec-09. Helped
contain pricing pressure.
Limited manouevrability in
increasing fixed price project
proportion.
Pricing pressure will remain
impacting margins.
Local hiring No such pressure in 2008-09
Higher visa rejection rates and
tighter labour laws have caused
IT cos to ramp up local hiring.
Potential upward pressure on
onsite wage costs.
Non-linear
initiatives
Not as big a focus area.
Focus on non-linear solutions to
fight pricing pressures and
create differentiation.
Upfront investments in these
limits margin defence ability.
Currency
Rupee weakened by 25% from
Rs40 in Jan-08 to Rs50 by Mar-
09.
Low probability of such a
correction in 2011-12.
Source: CLSA Asia-Pacific Markets
While currency calls are always tough, 20% rupee depreciation (like in 2008) from
current levels seems a low probability event. Moreover, given the experience of
2009/10 where IT vendors lost out on volume growth due to lack of people, Tier-1
techs are unlikely to try and operate at completely optimal levels of utilisation (Fig
11). Consequently, cost of bench will likely be higher limiting margin upsides.
Ability to push deals into fixed price projects will also be limited c.f. 2008-09. Note
that most vendors increased proportion of revenues from fixed price projects (Fig
10) by 10-15ppt in the previous slowdown to manage pricing pressures. Also, the
need to invest currently is higher than anytime in the past: Greater local hiring to
manage visa rejection issues and increased investments in non-linear initiatives
(platforms/solutions) to manage pricing pressures.
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