India IT: Back to business?::CLSA

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Back to business?
Tier-1 Indian Techs’ modest revenue report in the seasonally strongest
Sep quarter confirmed that business trends have been less than sanguine,
even as stocks have recovered 10-23% from their recent lows. With Dec
a seasonally weak quarter, revenue growth hopes have now been pushed
out to 2012 where macro challenges could de-rail the high expectations.
Our revised currency forecasts (Rs49 for 2HFY12, Rs48 for FY13) demand
a 2-6% EPS upgrade for the Tier-1 stocks, but we view these earnings
revisions, as late realignments versus the rally seen in tech stocks over
the last month. We continue to advise caution on Indian IT stocks.
Currency tailwinds have run their course
q CLSA’s view on a weaker Rupee has driven a change in currency assumptions
across all models. Versus Rs45/$ earlier, we now build-in Rs49/$ for 2HFY12 and
Rs48/$ for FY13.
q FY12 EPS upgrade: 2-6%; somewhat pulled down by forex hedge losses at TCS.
q FY13 EPS upgrade: 3-6%; as FY13 more fully benefits from currency.
q Meanwhile, stocks have rallied by 10% (HCL) to 23% (Infosys) over the last month.
In our view, the on-going currency resets across the street are lagging the stock
moves and are not an incremental trigger.
Back to business. Is demand really good?
q Sep-11 quarter revenue performance of Tier-1 vendors has provided little comfort
on the demand trajectory. Just a 5%QQ growth in constant currency terms in the
seasonally strongest quarter is hardly a sign of strong demand environment.
q Note that just 3 months back, Sep-11 revenue growth estimates were ~6-8%QQ
for Tier-1 techs and the companies have missed even moderated expectations.
q While vendors have been talking about strong deal pipelines, client commitments
on new deals need to translate into signings, and then into actual ramp-ups. There
continues to be some friction in both areas, given the macro environment.
q Increased competitive intensity in the sector, higher commoditisation of offerings
and greater pricing transparency in IT contracts is also keeping pricing subdued.
q Most vendors have been non-committal on 2012 outlook just yet. In this context,
expectations of solid revenue growth in FY13 are seemingly running ahead of reality
and we see downside risks to street revenue estimates.
Is the “base effect” finally catching up for Tier-1s?
q Tier-1 techs have successfully evaded repeated predictions of the “base-effect”, or
the expectation that their growth would slow down as they became bigger. Also,
Tier-1s have almost always grown revenues much faster than Tier-2 IT vendors.
q Sep-11 quarterly results reported thus far have however shown a unique
divergence in the growth prospects of Tier-1 and Tier-2 IT Services companies.
q Smaller vendors like Mindtree and Hexaware have reported stronger topline growth
even as Tier-1 peers’ performance has been modest. While performance in a couple
of quarters cannot be extrapolated, we would keep a close watch on trends here.
Stocks seem fully valued; take some money off the table
q Business environment will need to improve beyond current levels for street growth
projections to be met, in our view.
q We expect a pause in the stocks as they head for another re-test of demand in the
Dec-Jan timeframe. We expect no quick answers as deal decision making is still
patchy and deal wins need to seen in context of suddenly elevated consensus
assumptions, especially after Infosys’ 2HFY12 outlook.
q While a weaker currency can somewhat buffer the EPS risks ahead, valuation
multiples remain slaves of $-revenue growth and recognition of lower revenue
growth trajectory will impair valuations prospects as well.
q We currently have no positive recommendation in the Indian IT Services space.