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Technology
India
Question marks on earnings power unwarranted. Even as uncertainty on FY2013E
remains high and there could be potential downgrades ahead, we believe the Tier-I
stocks are reaching close to levels that would reflect pessimism on longer-term earnings
growth potential of these companies. We view such pessimism unwarranted. Growth
cyclicality in the secular market share gain story for the IT offshore names is not new.
Risk/reward is favorable even at current levels. TCS and Infosys are our top picks.
An uncertain FY2013E, but earnings growth power of Tier-I names intact, in our view
Borrowing from Mohnish Pabrai’s Dhandho Investor—‘Risk means the chance of a loss of capital.
Uncertainty is the range of different outcomes. So a stock may have high uncertainty but may not
be risky, if no one knows what will happen but the worst case scenario would not result in a huge
loss. These investments provide the greatest opportunities for investors.’
We believe the Tier-I Indian IT names are approaching levels (we are possibly 10-15% away) where
an uncertain macro environment is being extrapolated into a severe, sharp, and permanent loss of
earnings growth power of these companies. Business model, and consequently, earnings power of
these companies based upon market share gains for IT offshoring remains intact, in our view. Post
recent macro developments, we are headed into an uncertain environment and we do not know
how FY2013E would pan out—our estimates depict our current view on a highly uncertain
2HFY12E/ FY2013E; there could be downside risks—we present scenarios. Nonetheless, the key is
to appreciate the risk/reward at current levels—this appears favorable to us. We see the recent
correction as an opportunity to BUY into the long-term secular market share gain story for IT
offshoring through high-quality names. TCS and Infosys are our top picks.
A closer look at the potential worst-case, trading multiples, and risk-reward
We present FY2013E earnings scenarios for the Tier-I names in Exhibits 1-6. These stocks have
now corrected to 13-17X FY2013E worst-case EPS—not necessarily cheap but presenting a good
risk-reward ratio, in our view. We note that our worst-case EPS scenarios build in the possibility of
a Lehman repeat in terms of severe volume slowdown (though we still build in some growth) and
pricing correction. However, we do not factor in any of the upside risks in the form of (1) countercyclical
accelerated push for offshoring, (2) rupee depreciation, and (3) margin kicker from
enhanced ability to control wage costs in a low-growth environment. We note that all these
upside risks played out in the FY2009-10 timeframe—counter-cyclical benefits admittedly came
with a lag, but the rebound was sharp and substantial.
On trading multiples, we believe Infosys and TCS should bottom at normalized PE range of 12-14X
FY2013E—comprising an ex-growth multiple of 8X and assuming earnings grow at par with global
IT services spend growth to perpetuity beyond FY2013E. This bottom is still 10-15% away, but we
note that such fall would factor in a no market share gain scenario beyond a worst-case
FY2013E—as low as expectations should (not can) get. From an FCF perspective, to take Infosys as
an example, we estimate FY2013E FCF of Rs61 bn for the company in the worst case (see Exhibit
7)—implying an FCF yield (FCF/EV) of 5.9%, fairly attractive, in our view. A 10% correction in the
stock from current levels would take this yield to 6.9%.
Protectionist measures the key risk to our call
IT budget cuts for a year or two leading to volume slowdown and/or pricing pressure are likely but
would not impact our long-term positive view on revenue growth for the sector. However,
protectionism-related shocks are also a possibility and remain the key risk to our constructive
thesis.
How similar is Aug 2011 to Sep 2008?
Memories of the 2008 GFC and its delayed impact on offshore IT revenues are still fresh and
hence, the strong current micro indicators may not lend much confidence to the Street.
Macro uncertainty-wise, Aug 2011 has several similarities to Sep 2008—(1) serious question
marks on GDP growth in developed economies, the key client geographies for Indian IT
companies, (2) job cut scenario across industries, primarily BFSI, (3) strong likelihood of IT
budget cuts and severe slowdown in discretionary IT spends, and (4) increased volatility in
the currency markets. Worries of an impact on offshore IT services revenue growth hence
are not unwarranted.
Nonetheless, there is one key aspect that lends us confidence—Sep 2008 events came in as
a shock and led to a complete freeze in decision-making across corporate houses.
Companies, in general, are better prepared for a downturn today as macro environment has
remained uncertain since the last downturn. This has a major implication on offshore IT
services growth—decision-making is unlikely to come to a complete halt and hence, market
share gains for offshore players are likely to continue. Strong revenue growth for the sector
in FY2011/FY2012E has not come on the back of a sharp rebound in IT spends; it has been
driven by normalization of decision-making cycles leading to counter-cyclical market share
benefits for offshore names. Hence, even as IT budgets can possibly decline in CY2012E
depending on how macro pans out, FY2013E should see reasonable growth for Indian IT
services players as long as decision making cycles don’t get impacted substantially. Growth
could turn out to be lower than the 15-20% yoy that the market has been factoring in
before the recent fall; however, recent correction builds in revised lower growth
expectations and we see little risk of disappointment on the same.
Among other learnings from the post-Lehman shock phase and subsequent turnaround was
the ability of Tier-I Indian IT companies to protect (and even grow, currency supporting) their
operating margins in a low-growth environment. Even as most companies are running at
higher margins and higher utilization levels as compared to pre-Lehman days and may not
have similar margin protection ability, potential to control costs (especially wages) in a lowgrowth,
low-attrition environment can be substantial.
Where did the multiples bottom out in the last correction?
Tier-I stocks are trading at 2-4.4X post-Lehman lows—TCS at 4.2X, Infosys at 2X, Wipro at
2.7X, and HCLT at 4.4X, despite the recent correction. From an earnings perspective, TCS’
FY2013E worst-case EPS is 2.2X lowest FY2010 estimate post-Lehman, while Infosys is at
1.5X.
From a multiple perspective, TCS bottomed out at ~8X forward expectations (not actuals)
while Infosys bottomed out at ~12X—these stocks are currently at 15-17X worst-case EPS
scenario.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Technology
India
Question marks on earnings power unwarranted. Even as uncertainty on FY2013E
remains high and there could be potential downgrades ahead, we believe the Tier-I
stocks are reaching close to levels that would reflect pessimism on longer-term earnings
growth potential of these companies. We view such pessimism unwarranted. Growth
cyclicality in the secular market share gain story for the IT offshore names is not new.
Risk/reward is favorable even at current levels. TCS and Infosys are our top picks.
An uncertain FY2013E, but earnings growth power of Tier-I names intact, in our view
Borrowing from Mohnish Pabrai’s Dhandho Investor—‘Risk means the chance of a loss of capital.
Uncertainty is the range of different outcomes. So a stock may have high uncertainty but may not
be risky, if no one knows what will happen but the worst case scenario would not result in a huge
loss. These investments provide the greatest opportunities for investors.’
We believe the Tier-I Indian IT names are approaching levels (we are possibly 10-15% away) where
an uncertain macro environment is being extrapolated into a severe, sharp, and permanent loss of
earnings growth power of these companies. Business model, and consequently, earnings power of
these companies based upon market share gains for IT offshoring remains intact, in our view. Post
recent macro developments, we are headed into an uncertain environment and we do not know
how FY2013E would pan out—our estimates depict our current view on a highly uncertain
2HFY12E/ FY2013E; there could be downside risks—we present scenarios. Nonetheless, the key is
to appreciate the risk/reward at current levels—this appears favorable to us. We see the recent
correction as an opportunity to BUY into the long-term secular market share gain story for IT
offshoring through high-quality names. TCS and Infosys are our top picks.
A closer look at the potential worst-case, trading multiples, and risk-reward
We present FY2013E earnings scenarios for the Tier-I names in Exhibits 1-6. These stocks have
now corrected to 13-17X FY2013E worst-case EPS—not necessarily cheap but presenting a good
risk-reward ratio, in our view. We note that our worst-case EPS scenarios build in the possibility of
a Lehman repeat in terms of severe volume slowdown (though we still build in some growth) and
pricing correction. However, we do not factor in any of the upside risks in the form of (1) countercyclical
accelerated push for offshoring, (2) rupee depreciation, and (3) margin kicker from
enhanced ability to control wage costs in a low-growth environment. We note that all these
upside risks played out in the FY2009-10 timeframe—counter-cyclical benefits admittedly came
with a lag, but the rebound was sharp and substantial.
On trading multiples, we believe Infosys and TCS should bottom at normalized PE range of 12-14X
FY2013E—comprising an ex-growth multiple of 8X and assuming earnings grow at par with global
IT services spend growth to perpetuity beyond FY2013E. This bottom is still 10-15% away, but we
note that such fall would factor in a no market share gain scenario beyond a worst-case
FY2013E—as low as expectations should (not can) get. From an FCF perspective, to take Infosys as
an example, we estimate FY2013E FCF of Rs61 bn for the company in the worst case (see Exhibit
7)—implying an FCF yield (FCF/EV) of 5.9%, fairly attractive, in our view. A 10% correction in the
stock from current levels would take this yield to 6.9%.
Protectionist measures the key risk to our call
IT budget cuts for a year or two leading to volume slowdown and/or pricing pressure are likely but
would not impact our long-term positive view on revenue growth for the sector. However,
protectionism-related shocks are also a possibility and remain the key risk to our constructive
thesis.
How similar is Aug 2011 to Sep 2008?
Memories of the 2008 GFC and its delayed impact on offshore IT revenues are still fresh and
hence, the strong current micro indicators may not lend much confidence to the Street.
Macro uncertainty-wise, Aug 2011 has several similarities to Sep 2008—(1) serious question
marks on GDP growth in developed economies, the key client geographies for Indian IT
companies, (2) job cut scenario across industries, primarily BFSI, (3) strong likelihood of IT
budget cuts and severe slowdown in discretionary IT spends, and (4) increased volatility in
the currency markets. Worries of an impact on offshore IT services revenue growth hence
are not unwarranted.
Nonetheless, there is one key aspect that lends us confidence—Sep 2008 events came in as
a shock and led to a complete freeze in decision-making across corporate houses.
Companies, in general, are better prepared for a downturn today as macro environment has
remained uncertain since the last downturn. This has a major implication on offshore IT
services growth—decision-making is unlikely to come to a complete halt and hence, market
share gains for offshore players are likely to continue. Strong revenue growth for the sector
in FY2011/FY2012E has not come on the back of a sharp rebound in IT spends; it has been
driven by normalization of decision-making cycles leading to counter-cyclical market share
benefits for offshore names. Hence, even as IT budgets can possibly decline in CY2012E
depending on how macro pans out, FY2013E should see reasonable growth for Indian IT
services players as long as decision making cycles don’t get impacted substantially. Growth
could turn out to be lower than the 15-20% yoy that the market has been factoring in
before the recent fall; however, recent correction builds in revised lower growth
expectations and we see little risk of disappointment on the same.
Among other learnings from the post-Lehman shock phase and subsequent turnaround was
the ability of Tier-I Indian IT companies to protect (and even grow, currency supporting) their
operating margins in a low-growth environment. Even as most companies are running at
higher margins and higher utilization levels as compared to pre-Lehman days and may not
have similar margin protection ability, potential to control costs (especially wages) in a lowgrowth,
low-attrition environment can be substantial.
Where did the multiples bottom out in the last correction?
Tier-I stocks are trading at 2-4.4X post-Lehman lows—TCS at 4.2X, Infosys at 2X, Wipro at
2.7X, and HCLT at 4.4X, despite the recent correction. From an earnings perspective, TCS’
FY2013E worst-case EPS is 2.2X lowest FY2010 estimate post-Lehman, while Infosys is at
1.5X.
From a multiple perspective, TCS bottomed out at ~8X forward expectations (not actuals)
while Infosys bottomed out at ~12X—these stocks are currently at 15-17X worst-case EPS
scenario.
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