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Cutting target prices and estimates on macro concerns
While near-term demand for the top-tier vendors is intact, uncertain global
macroeconomic outlook could weigh on clients’ CY12E IT budgets. Our channel
checks suggest that clients will likely increase use of offshore delivery to cut
costs. Thus, owing to change in delivery mix in favour of offshore, we are lowering
FY13 earnings estimates by 2-10% for the top tier. In our view, TCS is ideally
placed to gain market share and worst case has an estimated 11% downside
potential. Reiterating TCS as our top pick and Buy on Infosys and Wipro.
No demand concerns yet
While heightened macroeconomic concerns in the western world threaten to derail demand for the sector, some leading indicators seem supportive. A look at some of the key indicators in the US (primary market, at 60% of revenues) suggests that unlike in the recession, (a) Tech Pulse Index (indicates health of technology spending) is now stable and (b) US equipment and software spending as a percentage of GDP is still below pre-recession levels. Moreover, while overall unemployment in the US is a key concern for most investors, unemployment in the technology sector is actually declining.
Slowdown could propel market share gains for top-tier Indian vendors
Since the other focus of world economic concern is Europe, and as Indian IT services companies derive a significant proportion of their revenues from banks headquartered in Europe, we recently spoke with the CIO’s/offshore vendor relationship managers at four of the top ten banks in Europe. The key message is: (a) current macroeconomic slowdown could boost offshoring and benefit large Indian vendors that are strategic partners, and (b) banks are inclined to do 'more with less' rather than pursue sharp price discounts. In our view, this means that the macro environment would likely have to get worse for absolute price declines.
Stress test suggests limited downside
Even in the worst case we estimate the downside potential to our Buy-rated stocks at 11-20%. This assumes a recession in the US and Europe (both geographies contribute 90% of the revenues of most Indian vendors) with a spending freeze for one or two quarters. Our base case is 10-15% growth, which assumes flat-to-marginal declines in technology budgets of clients for CY12E and a significant increase in offshore effort.
What could potentially trigger an upward rally
While a ‘negative newsflow’ environment will likely last the next two quarters, we believe quantification of clients’ budget expectations (vs. current qualitative positive tone) and benign currency environment could trigger an upward move.
Taking cognizance of risks; lowering multiples
We base our TPs on PEs relative to their historical trading range, to peers and growth rates. We reduce our TPs by 12-15% in part because of the higher proportion of effort offshore (78-79% vs. 75-76% in FY11). Offshore billing rates are one-third those of onsite and thus reduce realised revenues, offsetting some of the related benefit to margins. We have also cut target multiples (13-20x range vs. 18-25x at present) to reflect a substantially increased macro uncertainty. Key risks: Recession in the US and Europe impacting technology spend, higher-than-expected rupee appreciation.
Growth concerns seem overdone
Key highlights
Unlike the last downturn, the heightened concerns on macroeconomic outlook in the US and Europe have not impacted technology spending yet
The financial services sector, which contributes 30-40% of the revenues of the Indian vendors, is in much better health than in the recession
The US IT unemployment rate is declining and stood at 3.7% (vs. national average of 9.1%) at the end of August 2011. Positive for supply surplus sourcing destinations like India
IT services spending continues to expand despite the heightened macroeconomic concerns
Indian IT services vendors have their largest geographical exposure to the US (~50-65% of revenues) and financial services (~30-43% of revenues) is the largest vertical. Thus, a slowdown/recession in the US tends to have a direct impact on the business outlook for the financial services companies. In the latest edition of their Global Economic Perspectives published on 23 September 2011, Deutsche Bank’s US economists note that “the depressing effects of the wealth and confidence hits that households have suffered this summer are strong enough by themselves to push the economy very close to negative growth”. However, they also note that the important factors arguing for continued positive, albeit sluggish, growth are:
1. “The major cyclical component of consumer spending, durable goods, is already running at an unusually depressed level and has substantial upside potential
2. Another significant plus is a robust corporate sector and prospects for continued expansion in business spending which will support overall income growth”
In the past, US recession concerns have had an immediate impact on IT services spending by clients (especially financial services customers). However, this time around owing to the balance sheet strength of the US corporates, while concerns of the US economy slipping into recession are now elevated, there has been no slowdown in clients’ IT services spending.
Tech Pulse Index suggests stability in IT spending in the US
To substantiate our claim, we compare the change in the Federal Reserve’s Tech Pulse Index with changes in the US GDP growth forecast by Deutsche Bank economists. The Tech Pulse Index is an index of coincident indicators of activity in the US information technology sector. It can be interpreted as a summary statistic that tracks the health of the tech sector. Figure 1 demonstrates that tech spending in the US had started to slow at least two quarters before the start of the l recession. This also coincided with the sharp downward revision in growth forecasts for the economy. However, we have not seen a similar trend as yet, even though seemingly we are deep into a crisis
We believe that the fall in the Tech Pulse Index in the beginning of 2008 was on account of:
1. High proportion of discretionary spending (~30-35% of overall IT budgets) in the IT budgets of clients on the back of strong growth in IT budgets for the previous three fiscal years.
2. The sub-prime mortgage-induced financial crisis and recession had a direct impact on the health of the balance sheets of global banks and other financial services companies. Revenue from these contributes ~30-40% of the revenue of most Indian IT service vendors.
However, both of these issues seem to be absent this time around. Most of the IT services spending following the recession has been focused on cost cutting and thus had very little discretionary component. Our channel checks suggest that only 15-20% of clients’ CY11 IT budgets are towards discretionary spending. Also, most US corporates have very strong balance sheets with record levels of cash. We believe that these corporations will continue to invest in strategic cost-cutting initiatives, resulting in market share gains for the Indian vendors.
Slowdown could increase market share of offshore firms
Key highlights
Indian vendors have benefitted from the vendor consolidation that occurred after the downturn in CY08-09
With clients focusing on increasing usage of offshore to cut costs, preferred vendors are likely to gain share disproportionately
Less chance of significant price cuts; increasing offshore leverage is the first choice to cut costs
Regulation and compliance could be big drivers of spending in CY12E
Infosys has the best delivery; TCS is a willing partner
Slowdown in economic activity could increase share of offshore in CY12E IT budgets of financial services firms
Since the current focus of world economic concern is shifted to Europe, and because Indian IT services companies derive a significant portion of their revenues from banks headquartered in Europe, we recently spoke with the CIOs/offshore vendor relationship managers at four of the top ten banks in Europe. The banks are large clients of most top-tier Indian IT services companies. Our discussions were part of a study jointly undertaken by us and the Value Leadership Group consultancy in order to understand the current state of IT services spending at these banks and their near- and long-term strategy and outlook. The key message was that:
1. Current macroeconomic slowdown could boost offshoring and benefit large Indian vendors that are strategic partners and
2. Banks are inclined to do 'more with less' rather than pursue sharp price discounts.
In our view, this means that the macroeconomic environment would likely have to get much worse for absolute price declines to hurt growth and margins significantly. A brief synopsis of our key findings is discussed in the following paragraphs. For a detailed discussion, please refer to Appendix A.
Indian vendors are strategic IT partners
In our view, the biggest positive for the Indian IT services industry since the last downturn has been the recognition of its role as a ‘viable low-cost high-quality IT services delivery model’ across service functions. Most banks have embarked on long-term plans to increase delivery from offshore locations. We estimate these are likely to last until CY14-15E. Importantly, the banks rate the delivery quality of the Indian vendors at par with that of their MNC counterparts and view Indian vendors as strategic partners in this initiative. Thus, in our view, the current economic slowdown could in effect further accelerate market share gains by Indian vendors.
Preferred vendors are likely to gain share disproportionately
Based on our checks, TCS seems to be a relative winner, having acquired preferred vendor status with three of these four banks and top vendor status with two. It has benefitted from the vendor consolidation exercise undertaken by most banks after the last financial crisis. As the current economic slowdown in the western markets is likely to induce banks to increase offshore IT service spending, incumbents like TCS could arguably gain greater volume visibility.
Do ’more with less’: a better strategy than just price discounts
Our checks suggest that since the last recession, pricing has been under pressure. However, banks underscore that the value derived by getting extra work done offshore is much higher than asking for a price cut on the existing business. The former option helps banks get more for less by pushing work offshore, while it also aids offshore vendors in maintaining their margins. In our view, this means that the macroeconomic environment would likely have to get worse for absolute price declines to hurt growth and margins significantly.
Regulation and compliance could be big drivers of spending in CY12E
An increase in regulatory pressure in the US should drive IT services spending. The two key regulatory changes that could potentially drive spending are the Dodd-Frank Act and Basel III. Most global banks operating in the US will likely be compelled to upgrade their infrastructure to meet these requirements.
Infosys has the best delivery; TCS is a willing partner
Banking clients rate Infosys high for its quality of service; they say Infosys is tougher to negotiate with but sticks to deadlines; they add that its pricing across services continues to be at least 2-5% higher than the rest of the offshore vendors. TCS is known for its range of offerings and willingness to partner with clients even on seemingly difficult engagements. This approach helped TCS attain preferred vendor status with key large banks after the last financial crisis.
Cut price targets and estimates on macro concerns
Key highlights
Lower FY13 and FY14 earnings estimates by 2-10%
Our three Buy-rated stocks have a potential return of 18% (Wipro) to 25% (TCS)
Stable to positive CY12E IT service budgets of clients could potentially support the next upward move
Key assumption change – increase in offshore effort mix
For the sector, we are lowering our FY13 and FY14 earnings estimates by 2-10% due to a 4-8% reduction in revenue estimate and 3-10% reduction in EBITDA estimate for FY13.
Our key assumption change relates to higher proportion of efforts offshore. We have also assumed a weaker rupee for the forecast period vs. our previous assumption. While Deutsche Bank’s 12-month exchange target is INR45/USD, i.e. a 3.5% appreciation from Sept-Q FY12 average rates, we believe we have been conservative with 0.5% appreciation each quarter. Our present rupee assumptions are INR46.68/USD for FY12E, INR46.41/USD for FY13E and INR45.48 for FY14E.
What could potentially trigger an upward rally?
We believe we will continue to remain in a ‘negative newsflow’ environment for at least the next 1-2 quarters. However, further newsflow on either (a) a recession in Europe, (b) technology spending by large clients, and (c) deterioration of US GDP growth outlook will likely be negative but a confirmation of the downsides are already priced in. We would look at incremental upside/downside potential to our base-case scenario to evaluate the ‘negative newsflow’. The entire September quarter earnings season across the technology value chain will need to be keenly watched for cues from other technology sectors. Comments by software and service vendors at our recently concluded Technology Conference indicate that clients are continuing to spend as per plans and there have been no significant delays in decision making or deferrals of projects.
In this light, there are three events that we believe have the potential to trigger an upward rally:
A stronger-than-expected September quarter results season could add credibility to current growth estimates.
Commentary by leading Indian vendors in October 2011 (when they announce their September quarter results) about their deal pipelines, closures and near-term demand visibility. While they have been maintaining a cautiously optimistic stance, we believe a quantification of the impact or further granularity into their growth assumptions could go a long way in alleviating investor concerns.
Initial feedback from key clients of the Indian vendors about the quantum and of IT budgets for CY12.
Our new target prices imply 18-25% upside potential
Our three Buy-rated stocks have a potential return of 18% (Wipro) to 25% (TCS). We are cutting our target prices by 13-17% on (a) cut in estimates to factor in a shift in volumes in favour of offshore and (b) lower target multiple to account for an uncertain macro environment, which is most likely expected to continue for at least the next few quarters.
More than 90% of the revenues of most Indian IT services companies is derived from the developed markets. We are thus reducing our target multiples from 18-25x one-year forward to 13x-20x one-year forward earnings to factor in the global macro economic uncertainty which could potentially impact the pattern and manner of spending by clients of the Indian IT services companies.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Cutting target prices and estimates on macro concerns
While near-term demand for the top-tier vendors is intact, uncertain global
macroeconomic outlook could weigh on clients’ CY12E IT budgets. Our channel
checks suggest that clients will likely increase use of offshore delivery to cut
costs. Thus, owing to change in delivery mix in favour of offshore, we are lowering
FY13 earnings estimates by 2-10% for the top tier. In our view, TCS is ideally
placed to gain market share and worst case has an estimated 11% downside
potential. Reiterating TCS as our top pick and Buy on Infosys and Wipro.
No demand concerns yet
While heightened macroeconomic concerns in the western world threaten to derail demand for the sector, some leading indicators seem supportive. A look at some of the key indicators in the US (primary market, at 60% of revenues) suggests that unlike in the recession, (a) Tech Pulse Index (indicates health of technology spending) is now stable and (b) US equipment and software spending as a percentage of GDP is still below pre-recession levels. Moreover, while overall unemployment in the US is a key concern for most investors, unemployment in the technology sector is actually declining.
Slowdown could propel market share gains for top-tier Indian vendors
Since the other focus of world economic concern is Europe, and as Indian IT services companies derive a significant proportion of their revenues from banks headquartered in Europe, we recently spoke with the CIO’s/offshore vendor relationship managers at four of the top ten banks in Europe. The key message is: (a) current macroeconomic slowdown could boost offshoring and benefit large Indian vendors that are strategic partners, and (b) banks are inclined to do 'more with less' rather than pursue sharp price discounts. In our view, this means that the macro environment would likely have to get worse for absolute price declines.
Stress test suggests limited downside
Even in the worst case we estimate the downside potential to our Buy-rated stocks at 11-20%. This assumes a recession in the US and Europe (both geographies contribute 90% of the revenues of most Indian vendors) with a spending freeze for one or two quarters. Our base case is 10-15% growth, which assumes flat-to-marginal declines in technology budgets of clients for CY12E and a significant increase in offshore effort.
What could potentially trigger an upward rally
While a ‘negative newsflow’ environment will likely last the next two quarters, we believe quantification of clients’ budget expectations (vs. current qualitative positive tone) and benign currency environment could trigger an upward move.
Taking cognizance of risks; lowering multiples
We base our TPs on PEs relative to their historical trading range, to peers and growth rates. We reduce our TPs by 12-15% in part because of the higher proportion of effort offshore (78-79% vs. 75-76% in FY11). Offshore billing rates are one-third those of onsite and thus reduce realised revenues, offsetting some of the related benefit to margins. We have also cut target multiples (13-20x range vs. 18-25x at present) to reflect a substantially increased macro uncertainty. Key risks: Recession in the US and Europe impacting technology spend, higher-than-expected rupee appreciation.
Growth concerns seem overdone
Key highlights
Unlike the last downturn, the heightened concerns on macroeconomic outlook in the US and Europe have not impacted technology spending yet
The financial services sector, which contributes 30-40% of the revenues of the Indian vendors, is in much better health than in the recession
The US IT unemployment rate is declining and stood at 3.7% (vs. national average of 9.1%) at the end of August 2011. Positive for supply surplus sourcing destinations like India
IT services spending continues to expand despite the heightened macroeconomic concerns
Indian IT services vendors have their largest geographical exposure to the US (~50-65% of revenues) and financial services (~30-43% of revenues) is the largest vertical. Thus, a slowdown/recession in the US tends to have a direct impact on the business outlook for the financial services companies. In the latest edition of their Global Economic Perspectives published on 23 September 2011, Deutsche Bank’s US economists note that “the depressing effects of the wealth and confidence hits that households have suffered this summer are strong enough by themselves to push the economy very close to negative growth”. However, they also note that the important factors arguing for continued positive, albeit sluggish, growth are:
1. “The major cyclical component of consumer spending, durable goods, is already running at an unusually depressed level and has substantial upside potential
2. Another significant plus is a robust corporate sector and prospects for continued expansion in business spending which will support overall income growth”
In the past, US recession concerns have had an immediate impact on IT services spending by clients (especially financial services customers). However, this time around owing to the balance sheet strength of the US corporates, while concerns of the US economy slipping into recession are now elevated, there has been no slowdown in clients’ IT services spending.
Tech Pulse Index suggests stability in IT spending in the US
To substantiate our claim, we compare the change in the Federal Reserve’s Tech Pulse Index with changes in the US GDP growth forecast by Deutsche Bank economists. The Tech Pulse Index is an index of coincident indicators of activity in the US information technology sector. It can be interpreted as a summary statistic that tracks the health of the tech sector. Figure 1 demonstrates that tech spending in the US had started to slow at least two quarters before the start of the l recession. This also coincided with the sharp downward revision in growth forecasts for the economy. However, we have not seen a similar trend as yet, even though seemingly we are deep into a crisis
We believe that the fall in the Tech Pulse Index in the beginning of 2008 was on account of:
1. High proportion of discretionary spending (~30-35% of overall IT budgets) in the IT budgets of clients on the back of strong growth in IT budgets for the previous three fiscal years.
2. The sub-prime mortgage-induced financial crisis and recession had a direct impact on the health of the balance sheets of global banks and other financial services companies. Revenue from these contributes ~30-40% of the revenue of most Indian IT service vendors.
However, both of these issues seem to be absent this time around. Most of the IT services spending following the recession has been focused on cost cutting and thus had very little discretionary component. Our channel checks suggest that only 15-20% of clients’ CY11 IT budgets are towards discretionary spending. Also, most US corporates have very strong balance sheets with record levels of cash. We believe that these corporations will continue to invest in strategic cost-cutting initiatives, resulting in market share gains for the Indian vendors.
Slowdown could increase market share of offshore firms
Key highlights
Indian vendors have benefitted from the vendor consolidation that occurred after the downturn in CY08-09
With clients focusing on increasing usage of offshore to cut costs, preferred vendors are likely to gain share disproportionately
Less chance of significant price cuts; increasing offshore leverage is the first choice to cut costs
Regulation and compliance could be big drivers of spending in CY12E
Infosys has the best delivery; TCS is a willing partner
Slowdown in economic activity could increase share of offshore in CY12E IT budgets of financial services firms
Since the current focus of world economic concern is shifted to Europe, and because Indian IT services companies derive a significant portion of their revenues from banks headquartered in Europe, we recently spoke with the CIOs/offshore vendor relationship managers at four of the top ten banks in Europe. The banks are large clients of most top-tier Indian IT services companies. Our discussions were part of a study jointly undertaken by us and the Value Leadership Group consultancy in order to understand the current state of IT services spending at these banks and their near- and long-term strategy and outlook. The key message was that:
1. Current macroeconomic slowdown could boost offshoring and benefit large Indian vendors that are strategic partners and
2. Banks are inclined to do 'more with less' rather than pursue sharp price discounts.
In our view, this means that the macroeconomic environment would likely have to get much worse for absolute price declines to hurt growth and margins significantly. A brief synopsis of our key findings is discussed in the following paragraphs. For a detailed discussion, please refer to Appendix A.
Indian vendors are strategic IT partners
In our view, the biggest positive for the Indian IT services industry since the last downturn has been the recognition of its role as a ‘viable low-cost high-quality IT services delivery model’ across service functions. Most banks have embarked on long-term plans to increase delivery from offshore locations. We estimate these are likely to last until CY14-15E. Importantly, the banks rate the delivery quality of the Indian vendors at par with that of their MNC counterparts and view Indian vendors as strategic partners in this initiative. Thus, in our view, the current economic slowdown could in effect further accelerate market share gains by Indian vendors.
Preferred vendors are likely to gain share disproportionately
Based on our checks, TCS seems to be a relative winner, having acquired preferred vendor status with three of these four banks and top vendor status with two. It has benefitted from the vendor consolidation exercise undertaken by most banks after the last financial crisis. As the current economic slowdown in the western markets is likely to induce banks to increase offshore IT service spending, incumbents like TCS could arguably gain greater volume visibility.
Do ’more with less’: a better strategy than just price discounts
Our checks suggest that since the last recession, pricing has been under pressure. However, banks underscore that the value derived by getting extra work done offshore is much higher than asking for a price cut on the existing business. The former option helps banks get more for less by pushing work offshore, while it also aids offshore vendors in maintaining their margins. In our view, this means that the macroeconomic environment would likely have to get worse for absolute price declines to hurt growth and margins significantly.
Regulation and compliance could be big drivers of spending in CY12E
An increase in regulatory pressure in the US should drive IT services spending. The two key regulatory changes that could potentially drive spending are the Dodd-Frank Act and Basel III. Most global banks operating in the US will likely be compelled to upgrade their infrastructure to meet these requirements.
Infosys has the best delivery; TCS is a willing partner
Banking clients rate Infosys high for its quality of service; they say Infosys is tougher to negotiate with but sticks to deadlines; they add that its pricing across services continues to be at least 2-5% higher than the rest of the offshore vendors. TCS is known for its range of offerings and willingness to partner with clients even on seemingly difficult engagements. This approach helped TCS attain preferred vendor status with key large banks after the last financial crisis.
Cut price targets and estimates on macro concerns
Key highlights
Lower FY13 and FY14 earnings estimates by 2-10%
Our three Buy-rated stocks have a potential return of 18% (Wipro) to 25% (TCS)
Stable to positive CY12E IT service budgets of clients could potentially support the next upward move
Key assumption change – increase in offshore effort mix
For the sector, we are lowering our FY13 and FY14 earnings estimates by 2-10% due to a 4-8% reduction in revenue estimate and 3-10% reduction in EBITDA estimate for FY13.
Our key assumption change relates to higher proportion of efforts offshore. We have also assumed a weaker rupee for the forecast period vs. our previous assumption. While Deutsche Bank’s 12-month exchange target is INR45/USD, i.e. a 3.5% appreciation from Sept-Q FY12 average rates, we believe we have been conservative with 0.5% appreciation each quarter. Our present rupee assumptions are INR46.68/USD for FY12E, INR46.41/USD for FY13E and INR45.48 for FY14E.
What could potentially trigger an upward rally?
We believe we will continue to remain in a ‘negative newsflow’ environment for at least the next 1-2 quarters. However, further newsflow on either (a) a recession in Europe, (b) technology spending by large clients, and (c) deterioration of US GDP growth outlook will likely be negative but a confirmation of the downsides are already priced in. We would look at incremental upside/downside potential to our base-case scenario to evaluate the ‘negative newsflow’. The entire September quarter earnings season across the technology value chain will need to be keenly watched for cues from other technology sectors. Comments by software and service vendors at our recently concluded Technology Conference indicate that clients are continuing to spend as per plans and there have been no significant delays in decision making or deferrals of projects.
In this light, there are three events that we believe have the potential to trigger an upward rally:
A stronger-than-expected September quarter results season could add credibility to current growth estimates.
Commentary by leading Indian vendors in October 2011 (when they announce their September quarter results) about their deal pipelines, closures and near-term demand visibility. While they have been maintaining a cautiously optimistic stance, we believe a quantification of the impact or further granularity into their growth assumptions could go a long way in alleviating investor concerns.
Initial feedback from key clients of the Indian vendors about the quantum and of IT budgets for CY12.
Our new target prices imply 18-25% upside potential
Our three Buy-rated stocks have a potential return of 18% (Wipro) to 25% (TCS). We are cutting our target prices by 13-17% on (a) cut in estimates to factor in a shift in volumes in favour of offshore and (b) lower target multiple to account for an uncertain macro environment, which is most likely expected to continue for at least the next few quarters.
More than 90% of the revenues of most Indian IT services companies is derived from the developed markets. We are thus reducing our target multiples from 18-25x one-year forward to 13x-20x one-year forward earnings to factor in the global macro economic uncertainty which could potentially impact the pattern and manner of spending by clients of the Indian IT services companies.
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