India IT Services - Adjusting our price targets for the weak global macro, we still see 15-20% upside::JPMorgan

Please Share:: India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��


 We adjust our price targets and FY12/FY13 earnings estimates for Indian IT due to
the  weak  macro environment: J.P. Morgan  economist  Michael  Feroli cut  his  GDP
forecasts for 4Q CY11 and 1Q FY12 twice in August and now expects GDP to grow by
1.0% in 4Q CY11 and 0.5% in 1Q CY12, down from 3.0% and 2.0%, respectively, at the
end of July. Fortunes of Indian IT companies cannot be disconnected from the developed
market GDP trends, in our view. Accordingly, we lower our FY12/FY13 estimates and
reduce our price targets for the Big 4 (TCS, Infosys, Wipro, and HCLT) by 12-18%.
 We  believe  that  front-line  stocks  in  Indian  IT  can  grow  revenues  ~15%  (US$)  in
FY13: We  explained the  reasons  for  our  thinking  in  detail  in  our  two  prior  reports
dealing  with  recession  analysis  on  the  Indian  IT  sector  (see,  Lessons  from  the  2008
recession parts 1 and 2 dated Aug17
th
and Sep. 7
th
).
 It  also  bears  mentioning  that  we  think  IT  Services  spending  has  been  largely
disciplined since coming off the previous financial crisis: Since 2008, US IT Services
spending as a percent of US GDP has moderated, suggesting that excesses have not been
built  in  the  system. Client  firms,  in  general,  have  spent  thoughtfully  in  the  last  three
years.  This  implies  there  is  less  room  to  cut  budgets  this time  around.  Within  the  IT
Services spectrum, offshore  IT services tend to be the least cyclical and a much greater
play on operations/IT than capex.
 Consensus numbers have room  to move  downwards  by  about  5-6%, but we  think
the  stocks  have  already  priced  in  that  scenario  and  perhaps  more: At the start  of
upturns  and  downturns,  consensus  typically trails,  not  leads, because  consensus  rarely
captures the  turn  of  the  cycle. Perhaps price  action  has  already  substantially  occurred,
before consensus downgrades. As an example, consensus still has Infosys revenue growth
pegged at 20% US$ revenue growth (meeting Infosys’ FY12 revenue growth guidance),
but is Infosys’ stock price of Rs2,300 already telling us something else? If Infosys meets
its  revenue  guidance, implying that  stiffer back-ended  growth expectations in  2H FY12
are met, the stock might  rally.  In sum, we think stocks already price in disappointments
that consensus has not yet built in (to the extent of 5-6% downward revisions).
 Most stocks of Tier-1 companies in our universe could still return 15-20% over 6-9
months given current valuations of median less one standard deviation for all except
TCS: On a  risk-adjusted  basis, we prefer TCS  (OW)  for its proven  ability to  notch  up
market  share  gains, holding  margins.  HCLT  (OW)  could  be a  good  pick  provided  it
demonstrates it can hold (if not improve) EBIT margins through not just FY12 but FY13
as well. We are slightly more constructive on Infosys (Neutral) than in the past due to its
moderated valuation (more than 1 std. deviation below its five-year median P/E).


Price target and valuation analysis
Our Mar-12 price target for TCS is Rs1,175, based on a one-year
forward P/E of 19x, a modest premium to Infosys’ target multiple of
18x. We have reduced our target multiple to factor in macro weakness.
We believe the premium is justified as TCS has exhibited a much better
revenue growth profile over the last few quarters than Infosys and topline growth has been accompanied by improved profitability.
Risk-free rate: 6.50%
Market risk premium: 8.00%
Beta: 0.75
Debt/equity: 0.00%
Cost of debt: 8.00%
Terminal “g”: 4%
Source:  J.P. Morgan estimates.
In our view, risks to our PT are further weakness in the demand
environment, rupee appreciation (especially given that TCS has a lower
hedging position), and higher-than-expected wage expenses in variable
payouts.