Indian IT - Moderating earnings estimates and FY12 valuation multiples:: Kotak Sec,

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SECTOR UPDATE: IT
Indian IT - Moderating earnings estimates and FY12 valuation
multiples
In light of the recent weakness in the developed economies (USA and Europe are
the major markets for Indian IT services companies), we are moderating our earnings
assumptions for our coverage universe for FY12. We factor in a relatively lower
revenue growth (about 14% - 20% v/s 15% - 24% earlier for the Top 4 companies).
We have also assumed flat pricing for the next three quarters as compared to our
earlier assumption of a marginal rise. Consequently, the earnings growth for the Top
4 companies moderates to 4% - 25% from 6% - 31% earlier.
In view of the reduced growth rates, we are also moderating the valuations accorded
to stocks (from 20x – 24.5x to 17x – 21.7x for Top 4). For the large caps, we
now incorporate valuations similar to the average of the last cycle as compared to
the average of the high growth phase.
We have already incorporated these changes in our latest updates on Infosys,
Mphasis and R Systems. We are incorporating changes for other companies now.
We are maintaining our recommendations for all companies except for KPIT. We
upgrade KPIT to BUY from ACCUMULATE, looking at the significant upside potential.
Moderating revenue growth expectations
In view of the continuing weakness in developed economies, we are moderating our
revenue growth assumptions for companies under our coverage for FY12. This is
based on the assumption that, the uncertain macro scene may have an impact on
the near term volume growth. We have also assumed flat realisations in the next
three quarters of FY12 v/s our earlier assumption of a marginal growth. Consequently,
our revenue growth expectations stand moderated. We have already incorporated
a lower growth for Infosys, Mphasis and R Systems in our latest notes on
those companies.
We note that, companies have thus far not indicated any project cancellations or
large scale postponements. However, the macro scene has remained uncertain over
the past few months and any further weakness may impact the overall growth rates.
However, we do not expect growth rates to fall off sharply as in the case of previous
downturns. Moderate increases in budgets in past two years, conservative approach
of corporates and a relatively lower impact of the slowdown on corporates may prevent
a steep fall, we believe.
We have also incorporated flat realisations v/s 1QFY12 for the remainder of the year.
Earlier, we had assumed marginal growth in realisations. Of late, large companies
have commented on the challenges faced in getting realization increases from large
customers.
Earnings growth to be lower
In line with the reduction in revenue growth rates, earnings are also expected to
grow at a relatively slower pace. While companies will look at optimizing costs further,
we do expect earnings growth also to moderate. For the Top 4, EPS growth
could be 4% - 25% as compared to our earlier estimates of about 6% - 31%.
Lower target valuations
With lower expected growth rates, we are also according lower target valuations for
companies. For the large caps, we now incorporate valuations similar to the average
of the last cycle as compared to the average of the high growth phase. The relative
valuation differentials between companies are largely maintained.
Maintain most recommendations; KPIT upgraded
We are maintaining our recommendations on all stocks except KPIT. We had downgraded
KPIT post 1QFY12 results. The stock has come off significantly post that and
now offers 32% upside. Thus, we upgrade it to BUY. We maintain our large cap
picks of Infosys and TCS. NIIT Tech and KPIT are our preferred mid-caps.