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UBS Investment Research
Indian IT Services
F ive questions on Indian IT
Why are we worried about a slowdown in banking demand?
The banking, financial services and insurance (BFSI) sector makes up 40% of
exports for Indian vendors. In FY06-11, BFSI revenue grew at an average annual
rate of 27.7%, compared to 25.6% for the other industry verticals of large Indian
vendors. We are concerned that the recently-announced cost reduction initiatives in
many large banks will adversely impact demand, leading to lower revenue for the
Indian vendors.
Won’t cost pressures prompt further offshoring?
We believe structural supply shortages in the Western economies and the need for
cost efficiency will ensure continued offshoring to India. However, we expect a
slower pace of growth than the 20%-plus consensus estimates over the medium
term. We also anticipate a near-term disruption in revenue momentum as large
clients implement cost reductions measures in their IT departments.
Is calling for a structural derating unduly bearish?
The strong recovery in FY11 prompted us to question if we are underestimating the
resilience of the Indian IT services model. The revenue recovery did not translate
into strong earnings momentum for most vendors. Our other main concern for the
sector is margin erosion from rising cost pressures and slowing growth, which we
believe will depress earnings and de-rate stocks.
We remain negative on the sector’s outlook, no Buy-rated stocks
We remain negative on the sector and expect vendors to start becoming more
cautious on their outlook by late 2011 and early 2012. We retain Neutral ratings on
Tata Consultancy Services (TCS) and Infosys, with Sell ratings on all the other
stocks under our coverage.
1. Why are we worried about a slowdown in banking
demand?
One of the key reasons for our recent downgrade of the Indian IT services sector
(refer our note Indian IT Services: Demand headwinds to prompt de-rating,
published on 24 August 2011) is our view that demand from the BFSI sector
will likely come under pressure following the announcement of cost reduction
initiatives at large banking institutions. BFSI accounts for 40% of India’s
exports, and banking/financial services form roughly two-thirds of this exposure.
Historical analysis suggests that IT services spending in the BFSI sector
recorded a 9.2% CAGR in 2004-08, higher than the 6.2% CAGR for the other
verticals over the same period. For the Indian IT industry, BFSI revenue posted
a CAGR of 28%, while large vendors witnessed an over 35% CAGR in BFSI
revenue over the same period. BFSI currently contributes to nearly 40% of
incremental revenue for large Indian vendors, and we believe a slowdown in IT
services spending in the BFSI sector will likely impact revenue growth for these
companies.
2. Won’t cost pressures prompt further offshoring?
The need for cost efficiency has been one of the main reasons for outsourcing IT
services to India (the other being supply shortages in the West). Thus, it would
be logical to assume that cost reduction initiatives in client organisations would
result in increased offshoring. While we do not dispute this logic, we also expect
the following.
The impact of offshoring should be significantly lower given the strong shift
in growth after the recent recession (Indian vendors’ revenue grew 20-30%
in FY10, while global vendors struggled to expand).
Headcount reductions could disrupt the normal flow of operations in client
organisations, leading to delays in decision making.
Clients are unlikely to accept a pass-through of cost increases from the
vendors, let alone offer like-to-like billing rate hikes, which could impact
pricing power.
3. When do we expect demand to moderate?
We expect increased caution in management commentary over the next few
months and for the budgeting cycles in December 2011/January 2012 to offer
the first signs of a potential slowdown. We believe FY13 revenue will show the
full impact of a slowdown in demand, while FY12 will be less affected. As a
result, we significantly lowered our FY13 EPS estimates on 24 August 2011
We expect US dollar revenue in Q2 FY12 to remain relatively
strong for most vendors, while rupee revenue and operating margins could
benefit from a significant depreciation of the rupee against the US dollar.
4. Industry-wide slowdown or company-specific issues?
While Infosys has been sounding increasingly cautious on the demand outlook,
TCS and Cognizant have remained bullish. TCS’s CEO Mr N Chandrasekaran
recently noted that he had met 20-25 clients in the past few weeks, but has not
seen any cuts in discretionary spending. Given the relative weakness of Infosys
and Wipro over the past few quarters, it is tempting to write them off as being
due to company-specific issues rather than an industry-wide demand slowdown.
We believe this is merely a timing difference between the vendors due to their
different portfolios and client exposures. We expect vendors to sound more
similar in their outlook come December 2011/January 2012, when clients will be
close to announcing their budgets for 2012.
5. Is the call for a structural derating unduly bearish?
Given the significant drop in share prices in recent weeks, it is fair to evaluate if
a further derating is likely, especially if there is no risk of another recession in
the Western economies. PE multiples have corrected from their 23-25x peaks to
14-18x on a one-year forward basis, raising questions on whether these stocks
are undervalued at current levels. We estimate medium-term revenue growth
rates for the sector in the mid-to-high teens, with 10-16% earnings CAGRs in
FY11-16, compared to the 30-35% CAGRs in FY03-09. Valuations started to
slowly de-rate since the start of 2011 as earnings momentum began to slow. We
believe an impending slowdown will pose risks to current consensus revenue
and earnings estimates, triggering a structural derating for the sector. We view
14-18x PE multiples as fair value in the medium-term for the large cap stocks,
and hence, we think there is limited upside from the current levels.
Statement of Risk
We believe a significant decline in IT spending or currency appreciation could
result in downward revisions in earnings estimates and impact valuations
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
UBS Investment Research
Indian IT Services
F ive questions on Indian IT
Why are we worried about a slowdown in banking demand?
The banking, financial services and insurance (BFSI) sector makes up 40% of
exports for Indian vendors. In FY06-11, BFSI revenue grew at an average annual
rate of 27.7%, compared to 25.6% for the other industry verticals of large Indian
vendors. We are concerned that the recently-announced cost reduction initiatives in
many large banks will adversely impact demand, leading to lower revenue for the
Indian vendors.
Won’t cost pressures prompt further offshoring?
We believe structural supply shortages in the Western economies and the need for
cost efficiency will ensure continued offshoring to India. However, we expect a
slower pace of growth than the 20%-plus consensus estimates over the medium
term. We also anticipate a near-term disruption in revenue momentum as large
clients implement cost reductions measures in their IT departments.
Is calling for a structural derating unduly bearish?
The strong recovery in FY11 prompted us to question if we are underestimating the
resilience of the Indian IT services model. The revenue recovery did not translate
into strong earnings momentum for most vendors. Our other main concern for the
sector is margin erosion from rising cost pressures and slowing growth, which we
believe will depress earnings and de-rate stocks.
We remain negative on the sector’s outlook, no Buy-rated stocks
We remain negative on the sector and expect vendors to start becoming more
cautious on their outlook by late 2011 and early 2012. We retain Neutral ratings on
Tata Consultancy Services (TCS) and Infosys, with Sell ratings on all the other
stocks under our coverage.
1. Why are we worried about a slowdown in banking
demand?
One of the key reasons for our recent downgrade of the Indian IT services sector
(refer our note Indian IT Services: Demand headwinds to prompt de-rating,
published on 24 August 2011) is our view that demand from the BFSI sector
will likely come under pressure following the announcement of cost reduction
initiatives at large banking institutions. BFSI accounts for 40% of India’s
exports, and banking/financial services form roughly two-thirds of this exposure.
Historical analysis suggests that IT services spending in the BFSI sector
recorded a 9.2% CAGR in 2004-08, higher than the 6.2% CAGR for the other
verticals over the same period. For the Indian IT industry, BFSI revenue posted
a CAGR of 28%, while large vendors witnessed an over 35% CAGR in BFSI
revenue over the same period. BFSI currently contributes to nearly 40% of
incremental revenue for large Indian vendors, and we believe a slowdown in IT
services spending in the BFSI sector will likely impact revenue growth for these
companies.
2. Won’t cost pressures prompt further offshoring?
The need for cost efficiency has been one of the main reasons for outsourcing IT
services to India (the other being supply shortages in the West). Thus, it would
be logical to assume that cost reduction initiatives in client organisations would
result in increased offshoring. While we do not dispute this logic, we also expect
the following.
The impact of offshoring should be significantly lower given the strong shift
in growth after the recent recession (Indian vendors’ revenue grew 20-30%
in FY10, while global vendors struggled to expand).
Headcount reductions could disrupt the normal flow of operations in client
organisations, leading to delays in decision making.
Clients are unlikely to accept a pass-through of cost increases from the
vendors, let alone offer like-to-like billing rate hikes, which could impact
pricing power.
3. When do we expect demand to moderate?
We expect increased caution in management commentary over the next few
months and for the budgeting cycles in December 2011/January 2012 to offer
the first signs of a potential slowdown. We believe FY13 revenue will show the
full impact of a slowdown in demand, while FY12 will be less affected. As a
result, we significantly lowered our FY13 EPS estimates on 24 August 2011
We expect US dollar revenue in Q2 FY12 to remain relatively
strong for most vendors, while rupee revenue and operating margins could
benefit from a significant depreciation of the rupee against the US dollar.
4. Industry-wide slowdown or company-specific issues?
While Infosys has been sounding increasingly cautious on the demand outlook,
TCS and Cognizant have remained bullish. TCS’s CEO Mr N Chandrasekaran
recently noted that he had met 20-25 clients in the past few weeks, but has not
seen any cuts in discretionary spending. Given the relative weakness of Infosys
and Wipro over the past few quarters, it is tempting to write them off as being
due to company-specific issues rather than an industry-wide demand slowdown.
We believe this is merely a timing difference between the vendors due to their
different portfolios and client exposures. We expect vendors to sound more
similar in their outlook come December 2011/January 2012, when clients will be
close to announcing their budgets for 2012.
5. Is the call for a structural derating unduly bearish?
Given the significant drop in share prices in recent weeks, it is fair to evaluate if
a further derating is likely, especially if there is no risk of another recession in
the Western economies. PE multiples have corrected from their 23-25x peaks to
14-18x on a one-year forward basis, raising questions on whether these stocks
are undervalued at current levels. We estimate medium-term revenue growth
rates for the sector in the mid-to-high teens, with 10-16% earnings CAGRs in
FY11-16, compared to the 30-35% CAGRs in FY03-09. Valuations started to
slowly de-rate since the start of 2011 as earnings momentum began to slow. We
believe an impending slowdown will pose risks to current consensus revenue
and earnings estimates, triggering a structural derating for the sector. We view
14-18x PE multiples as fair value in the medium-term for the large cap stocks,
and hence, we think there is limited upside from the current levels.
Statement of Risk
We believe a significant decline in IT spending or currency appreciation could
result in downward revisions in earnings estimates and impact valuations
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