The bright spots- Infosys and HCL are our top picks  Motilal Oswal

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The bright spots
Cutting EPS estimates by 2-10%; Infosys and HCL are our top picks
 Increasingly weak global macro economic data implies deceleration in growth
for Indian IT companies. However, the decline in growth rates is unlikely to
be as severe as in FY09-10.
 Margin pressures will increase for most vendors in FY13.
 Expect revenue growth, valuation multiples to converge for Infosys and TCS.
 Prefer HCL Tech over Wipro on high revenue visibility, strong execution history.
 Infosys and HCL Tech are our top Buys in the large-cap IT space.
Weak global macro environment implies growth deceleration for Indian IT
In the last few months, increasingly weak macro economic data has been emanating from
both the US and Europe. While this implies deceleration in growth for Indian IT Services
companies, management commentary/guidance has remained positive. This has been
driven by strong growth outlook for FY12 (20-30% growth in USD revenues). While FY13
budgets are yet to be hinted, we expect a moderation in growth across the sector. We
trim our FY13 revenue estimates by 2-6% and EPS estimates by 2-10% for the top-tier
companies.
Impact in FY13 unlikely to be as severe as in FY09
We analyze the impact of recent global events on IT business under three scenarios for
FY13: (1) a normal year, with ~20% growth, (2) 3-4% cut in IT budgets as in 2003, implying
10-15% growth, and (3) 6-8% cut in IT budgets as in 2008, implying a 0-5% growth.
Scenario-2 is most likely in our view. FY13 is unlikely to map growth trends seen in
FY09-FY10. Factors that drive our view are:
1) Clients have been more cautious in their IT spends this time (According to TPI, TCV
of deals signed in CY10 (USD84b) is 5.1% lower than CY08 (USD88.5b) and 6.7%
lower than CY09 (USD90b).
2) Pricing is unlikely to see a sharp fall as:
(i) Billing rates in FY11 are lower than in FY09 (Infosys' per capita productivity fell
from USD87k in FY08 to USD82.5k in FY11)
(ii) Gross margins of vendors like HCL Tech and Cognizant are lower by 650bp and
200bp, respectively v/s FY09
(iii) Volumes are unlikely to see a sharp fall this time
3) Unlike the crisis of 2008, which was unprecedented, the current crisis has a clear
reference point, which will increase the preparedness of both vendors and clients.
Margin levers like utilization and salary may count for little in FY13
Unlike FY10, which saw an expansion in margins on the back of wage hike deferrals,
offshore shift and higher utilization (by some vendors), these levers are unlikely to be of
any significance in FY13, as companies are still likely to report lower double-digit growth
on a higher revenue base, implying gross headcount additions similar to FY12, despite
assumption of a 2% decline in attrition in FY12 and FY13.


Expect revenue growth, valuation multiples for Infosys and TCS to
converge
The key arguments in favor of higher multiple for TCS have been (1) revenue growth at the
higher end of the industry quartile, and (2) shrinking margin gap vis-à-vis Infosys. However,
sustaining growth on expanded revenue base in a weak environment would be a challenge
(revenue run-rate in 1QFY12 implies a revenue base of USD9.6b for FY12). Also, TCS has
limited headroom to improve margins, with most levers being exhausted through aggressive
cost management efforts.
On the other hand, Infosys' relatively lower growth is more a function of (1) revenue declines
from BT, (2) lack of tailwinds from strategic acquisitions like CGSL for TCS, and (3) the
organizational restructuring. With most of these headwinds behind it, Infosys' revenue
growth in FY13 could be similar to TCS. We note that Infosys' growth in BFSI would have
been higher than TCS if not for the latter's acquisition of CGSL. Moreover, our checks and
media reports suggest a more aggressive stance on acquisitions than in the past. Infosys
is also better placed to manage margins post restructuring, with a higher fungibility of
resources, allowing it to operate at utilization of 78-82% on a sustainable basis v/s the
average of 75.4% over the past 8 quarters.
HCL Tech v/s Wipro: Advantage HCL Tech
We prefer HCL Tech over Wipro on higher revenue visibility and strong execution history.
HCL Tech has consistently demonstrated its ability to win market share and achieve
industry leading growth irrespective of the macro environment. Valuations at 11.5x FY13E
EPS of INR35 are compelling. The company does not face the headwinds from a huge
hedge portfolio or declining margins in FY12 and FY13. Moreover, it is likely to continue
delivering industry-leading revenue and EPS growth in FY12 and FY13.
Wipro, on the other hand, has seen multiple leadership changes and has not been able to
demonstrate consistency in revenue growth or earnings. It has underperformed peers on
both revenue growth and margins over the past 5 quarters. While management commentary
indicates the possibility of matching if not outperforming industry growth by 4QFY12, we
would wait for fruition before going bullish. Valuations appear reasonable despite sharp
cut in estimates, but the company's core strategy appears to be still evolving.