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We expect the increased uncertainty about 2012 IT budgets caused by stronger macro
headwinds to have less of an impact on Indian IT Services than did the 2008-09 slowdown. Even
after downgrading our FY13F EPS for large-cap Indian IT companies by 6-8%, valuations look
reasonable to us.
Rational spending by clients implies the sector is better placed than in 2008-09
Spend on IT services by clients was at a measured pace post the 2008-09 slowdown, with much
of the sector growth coming from pent-up demand and restructuring of existing IT deals. Offshore
billing rates are still lower than before the previous slowdown. We expect better pricing discipline
among vendors because gross margins for some of them (Cognizant/HCLT) are much lower than
before the previous slowdown.
Nevertheless, given deteriorating macros, we expect clients to tread cautiously
We believe recent stronger macro headwinds will have an adverse near-term impact on business
confidence in the US and Europe, resulting in clients becoming more cautious about IT spending
and planning CY12 budgets. However, the current crisis relates more to the sovereign debt issue,
while US corporate balance sheets appear much healthier than during the previous downturn.
Hence, we expect spending to normalise by 2HCY12, after clients adjust to the new macro
environment. We do not expect any severe regulations on IT job outsourcing from developed
markets given the scarcity of computer engineers (especially in the US) despite any increasing
political noise going forward.
Sector valuations looks reasonable; we downgrade TCS to Hold, upgrade Wipro to Buy
We reduce our FY13F EPS for large-cap Indian IT companies by 6-8% given stronger macro
headwinds, but our revised PE valuations for FY12-13F look reasonable to us. In this state of
increased macro uncertainty, we prefer stocks with relatively low valuations, more revenue
diversity and higher flexibility in managing margins. Hence, we downgrade TCS and Info Edge to
Hold and upgrade Wipro to Buy from Hold. Infosys, HCL Tech and Wipro are our top large-cap
picks. Polaris is our top mid-cap pick. Stock correction resulting from further macro news flow is
possible, but over the medium to longer term we expect valuation multiples to improve given a
likely rebound in earnings growth from 2HCY12. Any sharp deterioration in the macro
environment in the US and Europe is a key risk.
Valuation looks reasonable to us
Given stronger macro headwinds, we reduce our FY13F EPS for Indian IT large caps 6-8%.
However, our revised PE valuations for FY12F/FY13F look reasonable to us. We downgrade
TCS and Info Edge to Hold and upgrade Wipro to Buy.
Our revised PE valuations for FY12-13F look reasonable to us, even though we reduce our
FY13F EPS for Indian IT large caps 6-8% (please see Table 1 for details on our earnings
revisions) to factor in the stronger macro headwinds. In this increased state of macro uncertainty,
we prefer stocks with relatively low valuations, more revenue diversity by verticals and higher
flexibility in managing margins. Hence we downgrade TCS and Info Edge to Hold, and upgrade
Wipro to Buy from Hold. Infosys, HCL Tech and Wipro are our top large-cap picks. Polaris is our
top pick in mid caps. Stocks reacting negatively to more macro news flow from here is possible,
but over the medium to longer term, we expect valuation multiples to improve given the likely
rebound in earnings growth from 2H12. Any sharp deterioration in the economic environment in
the US and Europe is a key risk.
We look for the impact of the slowdown to be sharper in FY13 than in FY12 because we expect
CY12 IT budgets to be cautious and volume growth to slow beginning in the latter part of 2HFY12.
This should lead to low exit rates entering FY13 for most stocks under our coverage. Our revised
earnings forecasts now factor in a INR/USD rate of Rs45.3/Rs44.7/Rs44.0 for FY12/FY13/FY14
versus earlier estimates of Rs44.5/Rs44.0/Rs44.0.
Valuation methodology
Our valuation methodology remains unchanged. We value Infosys on a forward PE basis, based
on the earnings growth potential we see for it in FY12-FY14. Other stocks have been valued on a
discount/premium to Indian IT industry benchmark Infosys. However, we continue to value
Satyam Computers on a forward EV/EBITDA multiple, considering the high volatility of items that
fall below its EBITDA line due to restructuring, as well as various pending litigation issues and
their resulting impact on cash flow, other income and tax provisions.
We downgrade our target PE multiple for Infosys by 8-10% to about 18x versus our projected EPS
CAGR of 17% over FY12-14F. This is at a discount to the last three-year average of the one-year
forward PE of 19x, as we factor in increased risk on sector earnings in the near to medium term.
We will revisit our target multiple, depending on further upside/downside risk to our revised
earnings forecasts.
Downgrade TCS to Hold from Buy
We downgrade TCS to Hold from Buy given its: 1) relative outperformance to the BSE IT index ytd
by 16%; 2) low diversification beyond banking, financial services and insurance (BFSI), which still
contributes 43% of revenues – where most macro uncertainty is coming through higher employee
layoffs and bond asset markdowns by global banks; and 3) low headroom in managing margin
given its excellent performance resulting in EBITDA margins improving more than its Indian peers,
by 482bp in FY11 over FY08. This has led to most of its margin levers, including employee
utilisation, fixed price contribution and SG&A leverage, running much higher than peers.
Considering these and macro risks, we reduce our FY13F and FY14F EPS for TCS 6% each.
We now factor the TCS-specific risk to earnings, as mentioned above, into our PE multiple and
downgrade our target PE premium to Infosys’s target PE to 5% versus our earlier premium of
10%. Our revised target price of Rs1105 implies a FY13F PE of about 19x, offering potential
upside of just 7%. Even our valuation check through forward PE and P/B multiples with negative 1
standard deviation (SD) to the mean (over the past five to six years) indicates that TCS is trading
above the negative 1 SD to the mean on a P/B basis. It is trading marginally above its mean on a
PE basis while peers trade below the negative 1 SD, indicating the risk/reward is unfavourable at
current levels. Hence we downgrade TCS to Hold.
Upgrade Wipro to Buy from Hold
We upgrade Wipro to Buy given: 1) its recent sharp correction of 30% ytd, underperforming the
BSE IT index by 4%, and resulting low valuations (currently trading at a 12% and 28% discount to
its three- and five-year average forward PE valuations, respectively, which in our view factors in
more than the risk related to Wipro’s declining revenue wallet share); and 2) our channel checks
indicate that ongoing reorganisation has led to materially more large deal activity, which may
result in a positive earnings surprise over the medium term and a valuation re-rating. We accept
that material reorganisation and stronger macro headwinds will result in no immediate turnaround
in earnings. However, steps taken to restructure sales efforts appear to be moving in the right
direction, in our view, to regain lost revenue wallet share. Considering the macro headwinds, we
reduce our FY12F, FY13F and FY14F EPS by 2%, 6% and 7%, respectively. Even at our reduced
earnings forecasts, PE valuations of 15/14x for FY12F/FY13F look cheap to us.
We reduce our PE-based valuation discount to Infosys to about 10% from our previous 15% given
our increased confidence relating to organisational restructuring. Our revised target price of
Rs400 implies a FY13F PE of about 16x, offering potential upside of 18%. Even our valuation
check through forward PE and P/B multiples with negative 1 SD to the mean (over the past five to
six years) indicates that Wipro now trades below the negative 1 SD to the mean, indicating the
risk/reward is favourable at current levels. Hence we upgrade Wipro to Buy. Also, given already
low Bloomberg consensus growth estimates, we believe that even a small turnaround in Wipro’s
growth profile versus its peers will lead to a material re-rating in the stock.
Downgrade Info Edge to Hold from Buy
We downgrade Info Edge to Hold given: 1) we expect Indian IT companies to become more
circumspect about lateral hiring, which typically has a disproportionate impact on the jobs
business, the main revenue and operating profit contributor; 2) Indian GDP growth has moderated
over the past few quarters (7.7% in 1Q12), which implies domestic growth may not be able to
offset the potential slowdown in the IT sector; and 3) the company’s real estate broking arm
AllCheckDeals could continue to be affected by legal disputes about land acquisition in Noida, its
largest market. However, we believe the impact could be much lower than in the previous
downturn, when revenues troughed at a 16% yoy decline, because we expect companies to move
to a normalised hiring pattern by June 2012, after clients become less cautious in their spending
approach. We lower our FY12F and FY13F revenues 9% and 10%, respectively. Given high
operating leverage, we reduce our FY12F and FY13F EPS 15% and 18%.
Based on our earnings downgrades, we lower our DCF-based target price to Rs725 (from Rs864).
Info Edge stock has outperformed the BSE IT index by 31% ytd. At current levels, the stock does
not leave much room for disappointment, in our view. A key metric to track going forward will be
the Naukri JobSpeak index, which has been a fairly accurate lead indicator during the previous
downturn and subsequent recovery. Hence, we downgrade to Hold from Buy.
We maintain our earnings forecasts for Hexaware and MphasiS
We maintain our earnings forecasts for Hexaware and MphasiS because we had factored in the
impact on earnings from stronger macro headwinds in our Well poised report on Hexaware dated
24 August 2011 and our Unfavourable risk-reward 3Q11 result update on MphasiS dated 26
August 2011.
Key risks to our cautiously optimistic outlook
Key downside risks to our target prices and ratings are: 1) any significant deterioration in
macroeconomic conditions in developed markets; 2) rupee appreciation beyond the levels that we
assume and/or adverse cross-currency movement; 3) lower pricing than that built into our
assumptions; and 4) strong regulatory action against outsourcing in Indian IT’s key geographic
markets.
Key upside risks to our target prices and ratings are: 1) any faster recovery in macroeconomic
conditions in developed markets; 2) any sharp rupee depreciation and/or favourable crosscurrency
movement; and 3) higher pricing than that built into our assumptions.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
We expect the increased uncertainty about 2012 IT budgets caused by stronger macro
headwinds to have less of an impact on Indian IT Services than did the 2008-09 slowdown. Even
after downgrading our FY13F EPS for large-cap Indian IT companies by 6-8%, valuations look
reasonable to us.
Rational spending by clients implies the sector is better placed than in 2008-09
Spend on IT services by clients was at a measured pace post the 2008-09 slowdown, with much
of the sector growth coming from pent-up demand and restructuring of existing IT deals. Offshore
billing rates are still lower than before the previous slowdown. We expect better pricing discipline
among vendors because gross margins for some of them (Cognizant/HCLT) are much lower than
before the previous slowdown.
Nevertheless, given deteriorating macros, we expect clients to tread cautiously
We believe recent stronger macro headwinds will have an adverse near-term impact on business
confidence in the US and Europe, resulting in clients becoming more cautious about IT spending
and planning CY12 budgets. However, the current crisis relates more to the sovereign debt issue,
while US corporate balance sheets appear much healthier than during the previous downturn.
Hence, we expect spending to normalise by 2HCY12, after clients adjust to the new macro
environment. We do not expect any severe regulations on IT job outsourcing from developed
markets given the scarcity of computer engineers (especially in the US) despite any increasing
political noise going forward.
Sector valuations looks reasonable; we downgrade TCS to Hold, upgrade Wipro to Buy
We reduce our FY13F EPS for large-cap Indian IT companies by 6-8% given stronger macro
headwinds, but our revised PE valuations for FY12-13F look reasonable to us. In this state of
increased macro uncertainty, we prefer stocks with relatively low valuations, more revenue
diversity and higher flexibility in managing margins. Hence, we downgrade TCS and Info Edge to
Hold and upgrade Wipro to Buy from Hold. Infosys, HCL Tech and Wipro are our top large-cap
picks. Polaris is our top mid-cap pick. Stock correction resulting from further macro news flow is
possible, but over the medium to longer term we expect valuation multiples to improve given a
likely rebound in earnings growth from 2HCY12. Any sharp deterioration in the macro
environment in the US and Europe is a key risk.
Valuation looks reasonable to us
Given stronger macro headwinds, we reduce our FY13F EPS for Indian IT large caps 6-8%.
However, our revised PE valuations for FY12F/FY13F look reasonable to us. We downgrade
TCS and Info Edge to Hold and upgrade Wipro to Buy.
Our revised PE valuations for FY12-13F look reasonable to us, even though we reduce our
FY13F EPS for Indian IT large caps 6-8% (please see Table 1 for details on our earnings
revisions) to factor in the stronger macro headwinds. In this increased state of macro uncertainty,
we prefer stocks with relatively low valuations, more revenue diversity by verticals and higher
flexibility in managing margins. Hence we downgrade TCS and Info Edge to Hold, and upgrade
Wipro to Buy from Hold. Infosys, HCL Tech and Wipro are our top large-cap picks. Polaris is our
top pick in mid caps. Stocks reacting negatively to more macro news flow from here is possible,
but over the medium to longer term, we expect valuation multiples to improve given the likely
rebound in earnings growth from 2H12. Any sharp deterioration in the economic environment in
the US and Europe is a key risk.
We look for the impact of the slowdown to be sharper in FY13 than in FY12 because we expect
CY12 IT budgets to be cautious and volume growth to slow beginning in the latter part of 2HFY12.
This should lead to low exit rates entering FY13 for most stocks under our coverage. Our revised
earnings forecasts now factor in a INR/USD rate of Rs45.3/Rs44.7/Rs44.0 for FY12/FY13/FY14
versus earlier estimates of Rs44.5/Rs44.0/Rs44.0.
Valuation methodology
Our valuation methodology remains unchanged. We value Infosys on a forward PE basis, based
on the earnings growth potential we see for it in FY12-FY14. Other stocks have been valued on a
discount/premium to Indian IT industry benchmark Infosys. However, we continue to value
Satyam Computers on a forward EV/EBITDA multiple, considering the high volatility of items that
fall below its EBITDA line due to restructuring, as well as various pending litigation issues and
their resulting impact on cash flow, other income and tax provisions.
We downgrade our target PE multiple for Infosys by 8-10% to about 18x versus our projected EPS
CAGR of 17% over FY12-14F. This is at a discount to the last three-year average of the one-year
forward PE of 19x, as we factor in increased risk on sector earnings in the near to medium term.
We will revisit our target multiple, depending on further upside/downside risk to our revised
earnings forecasts.
Downgrade TCS to Hold from Buy
We downgrade TCS to Hold from Buy given its: 1) relative outperformance to the BSE IT index ytd
by 16%; 2) low diversification beyond banking, financial services and insurance (BFSI), which still
contributes 43% of revenues – where most macro uncertainty is coming through higher employee
layoffs and bond asset markdowns by global banks; and 3) low headroom in managing margin
given its excellent performance resulting in EBITDA margins improving more than its Indian peers,
by 482bp in FY11 over FY08. This has led to most of its margin levers, including employee
utilisation, fixed price contribution and SG&A leverage, running much higher than peers.
Considering these and macro risks, we reduce our FY13F and FY14F EPS for TCS 6% each.
We now factor the TCS-specific risk to earnings, as mentioned above, into our PE multiple and
downgrade our target PE premium to Infosys’s target PE to 5% versus our earlier premium of
10%. Our revised target price of Rs1105 implies a FY13F PE of about 19x, offering potential
upside of just 7%. Even our valuation check through forward PE and P/B multiples with negative 1
standard deviation (SD) to the mean (over the past five to six years) indicates that TCS is trading
above the negative 1 SD to the mean on a P/B basis. It is trading marginally above its mean on a
PE basis while peers trade below the negative 1 SD, indicating the risk/reward is unfavourable at
current levels. Hence we downgrade TCS to Hold.
Upgrade Wipro to Buy from Hold
We upgrade Wipro to Buy given: 1) its recent sharp correction of 30% ytd, underperforming the
BSE IT index by 4%, and resulting low valuations (currently trading at a 12% and 28% discount to
its three- and five-year average forward PE valuations, respectively, which in our view factors in
more than the risk related to Wipro’s declining revenue wallet share); and 2) our channel checks
indicate that ongoing reorganisation has led to materially more large deal activity, which may
result in a positive earnings surprise over the medium term and a valuation re-rating. We accept
that material reorganisation and stronger macro headwinds will result in no immediate turnaround
in earnings. However, steps taken to restructure sales efforts appear to be moving in the right
direction, in our view, to regain lost revenue wallet share. Considering the macro headwinds, we
reduce our FY12F, FY13F and FY14F EPS by 2%, 6% and 7%, respectively. Even at our reduced
earnings forecasts, PE valuations of 15/14x for FY12F/FY13F look cheap to us.
We reduce our PE-based valuation discount to Infosys to about 10% from our previous 15% given
our increased confidence relating to organisational restructuring. Our revised target price of
Rs400 implies a FY13F PE of about 16x, offering potential upside of 18%. Even our valuation
check through forward PE and P/B multiples with negative 1 SD to the mean (over the past five to
six years) indicates that Wipro now trades below the negative 1 SD to the mean, indicating the
risk/reward is favourable at current levels. Hence we upgrade Wipro to Buy. Also, given already
low Bloomberg consensus growth estimates, we believe that even a small turnaround in Wipro’s
growth profile versus its peers will lead to a material re-rating in the stock.
Downgrade Info Edge to Hold from Buy
We downgrade Info Edge to Hold given: 1) we expect Indian IT companies to become more
circumspect about lateral hiring, which typically has a disproportionate impact on the jobs
business, the main revenue and operating profit contributor; 2) Indian GDP growth has moderated
over the past few quarters (7.7% in 1Q12), which implies domestic growth may not be able to
offset the potential slowdown in the IT sector; and 3) the company’s real estate broking arm
AllCheckDeals could continue to be affected by legal disputes about land acquisition in Noida, its
largest market. However, we believe the impact could be much lower than in the previous
downturn, when revenues troughed at a 16% yoy decline, because we expect companies to move
to a normalised hiring pattern by June 2012, after clients become less cautious in their spending
approach. We lower our FY12F and FY13F revenues 9% and 10%, respectively. Given high
operating leverage, we reduce our FY12F and FY13F EPS 15% and 18%.
Based on our earnings downgrades, we lower our DCF-based target price to Rs725 (from Rs864).
Info Edge stock has outperformed the BSE IT index by 31% ytd. At current levels, the stock does
not leave much room for disappointment, in our view. A key metric to track going forward will be
the Naukri JobSpeak index, which has been a fairly accurate lead indicator during the previous
downturn and subsequent recovery. Hence, we downgrade to Hold from Buy.
We maintain our earnings forecasts for Hexaware and MphasiS
We maintain our earnings forecasts for Hexaware and MphasiS because we had factored in the
impact on earnings from stronger macro headwinds in our Well poised report on Hexaware dated
24 August 2011 and our Unfavourable risk-reward 3Q11 result update on MphasiS dated 26
August 2011.
Key risks to our cautiously optimistic outlook
Key downside risks to our target prices and ratings are: 1) any significant deterioration in
macroeconomic conditions in developed markets; 2) rupee appreciation beyond the levels that we
assume and/or adverse cross-currency movement; 3) lower pricing than that built into our
assumptions; and 4) strong regulatory action against outsourcing in Indian IT’s key geographic
markets.
Key upside risks to our target prices and ratings are: 1) any faster recovery in macroeconomic
conditions in developed markets; 2) any sharp rupee depreciation and/or favourable crosscurrency
movement; and 3) higher pricing than that built into our assumptions.
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