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Action: Prefer HCL Tech followed by Infosys
HCLT is our top pick within tier 1 IT on expectations of strong revenue
growth (5.4% q-q), lower EBITDA margin declines despite wage hikes, on
rupee depreciation and reasonable valuation comfort. At Infosys, we
expect a cut in revenue growth guidance and think any fall in the stock
should be used as an opportunity to add positions as we believe prices
already factor in a moderation in growth. We remain cautious on TCS and
CTSH on high BFSI/Europe/Client concentration exposure and lower
valuation comfort. Wipro remains our least-preferred stock in tier 1 IT.
Catalyst: Stability in macroeconomic conditions and continuation of
rupee depreciation trends would be potential positive triggers for IT
stocks.
No material revenue growth moderation in 2Q
We expect USD revenue growth of 3.4-6.5% q-q across tier 1 IT
companies, with CTSH and TCS leading on revenue growth. Infosys and
Wipro should be in line with guidance. The impact of the recent economic
slowdown is unlikely to be visible in results this quarter, in our view.
Likely FY12F revenue guidance cut at Infosys, EPS guidance raise
The first impact of the slowdown, in our view, would be with Infosys cutting
its FY12F revenue growth guidance to 16-18% (from 18-20%) as
discretionary demand tapers and cross-currency impacts hurt USD
revenue growth. However, we see EPS guidance being raised to around
INR135 (from INR128-130) largely driven by rupee depreciation and
optimized hiring towards year-end.
Valuation: EPS up on rupee depreciation; upgrade Patni to Neutral
We revised our EPS estimates higher as we factor a new FY13F USD-INR
rate of 45 vs 44 earlier. We upgrade Patni to Neutral from Reduce.
Strong quarter: no material revenue
growth moderation, positive rupee
depreciation impact
We expect a strong 2QFY12 performance from tier 1 IT companies driven by a likely
limited impact from current economic uncertainty on demand and an expected significant
positive impact from recent rupee depreciation vs the USD (2.5% q-q on the average for
2QFY12 and 9.6% q-q on the closing rate). We expect the impact of the slowdown to
start to be visible in the 3QFY12 commentaries of managements as they get greater
clarity on FY13 budgets and the repercussions of the slowdown start to be seen in
4QFY12F in terms of revenue growth. Our FY13F estimates for tier 1 IT companies build
low-teen revenue growths vs an average of 22% growth in FY12F.
Infosys is likely to benefit most from rupee depreciation, in our view, compared with TCS
and Wipro, on account of Infosys’ lower hedging levels. We estimate Infosys will beat its
2Q EPS guidance by ~20%.
USD revenue growth in 2Q FY12F is likely to be in the range of 3.4-6.5% for tier 1
players (including Cognizant), on our estimates, partly moderated by a ~40-70bp impact
of adverse cross-currency moves. We expect volume growth to be in the range of 4-7%,
with stable pricing. In our view, Cognizant, TCS and HCL Tech will do better on revenue
growth vs the other tier 1 companies while Wipro could continuing to lag. We look for
Infosys’ revenue growth to be in line with its guidance for the quarter.
Margins are likely to look up on rupee depreciation, with Infosys expected to gain the
most, in our view. TCS’s margin positives on rupee depreciation will likely be offset
somewhat by a ~70-80bp impact of promotions, while Wipro and HCL Tech’s margins
are expected to be depressed by wage inflation, cushioned to some extent by rupee
depreciation. Typically, the sensitivity of the margins to 1% rupee depreciation is on the
order of 40-50bps for Indian IT companies, based on our calculations.
Earnings are likely to be a mixed bag depending on hedging levels and timing of wage
hikes. We expect Infosys to post the best q-q EPS growth of 18.6%.
Key things to watch out for
• Infosys guidance: A downward revision of its FY12F USD revenue growth guidance to
16-18% (vs 18-20% earlier) looks likely to us on 1) adverse cross-currency impact on
USD revenues; and 2) growth moderation, especially in discretionary segments with tail
revenues of consulting engagements likely to be deferred. We expect EPS guidance to
be raised to around INR135 (from INR128-130 earlier) primarily on the back of rupee
depreciation and hiring optimization towards the end of the year. We believe the market
would react negatively if Infosys’ EPS guidance falls short of INR135.
• Overall demand commentary: We expect status quo in terms of demand commentaries
by companies as: 1) a look into FY13F budgets will likely be limited; and 2) clients
would have had not enough time to react to the recent macro-economic developments.
We see the impact on demand largely starting to be reflected in commentaries in
3QFY12F and in revenues from 4QFY12F onwards.
• Package implementation, Europe and BFSI demand: These are the first segments in
our view likely to be impacted by the current economic deterioration; we expect growth
and outlooks in these segments will be keenly watched.
• Infrastructure management services (IMS) demand and corresponding deal flow: We
recommend watching for growth in IMS and deal commentary by TCS and HCL Tech in
particular on re-bid deals, to corroborate our view that re-bid/cost or efficiency-focussed
deals are unlikely to be pushed back.
• Hiring commentary: Any curtailments in hiring and improvement in utilization
expectations should be taken as corroboration of our view that revenue moderation will
likely lead to cost moderation.
Infosys guidance cut – sentimentally negative, but in the price
We expect Infosys to reduce FY12F USD revenue growth guidance from 18-20% to 16-
18% on account of 1) cross-currency impact being negative on USD revenue growth;
and 2) growth moderation, especially in discretionary demand as tail projects post
consulting engagements start to get deferred. The pick-up in discretionary demand in
2HFY12 was a key assumption in Infosys’ back-ended growth guidance for FY12F, in
our view.
We, however, expect the company to raise its EPS guidance to around INR135 (from
INR128-130 earlier) and its EBITDA margin decline guidance to be revised to 200bps
(from a 250bp decline earlier) on account of 1) rupee depreciation; and 2) hiring
optimization going into 4QFY12F – especially in terms of laterals. Infosys had earlier
indicated that it would be hiring 45,000 people in FY12F. This number, in our view, was
~3-4% higher than what their top-end revenue growth guidance of 20% implied. This
would now be optimized for the lower growth expectations. We do not expect the
company to lower its fresher hiring targets.
We see this development as a sentimental negative, but do not see a material price
impact of this move as our expectations, as well as consensus, already build in no
outperformance vs guidance. Any adverse stock reactions on account of this move
should be used to add positions, in our view.
View unchanged – Demand moderation likely to be less
severe than last time around, Prefer HCL Tech/Infosys
Our view remains that this downturn is not as severe as the post-Lehman crisis
downturn, with the key reasons being:
• Fundamental positioning of Indian IT players is much stronger now than during the
previous downturn, with participation rates in deals increasing.
• Clients are in much better shape and are not facing an existential crisis – hence while
we see cuts, we do not expect them to be as sharp as those during the last downturn.
Moreover, we have not seen overspending on technology in the recent past for it to be
cut materially.
• Pricing is still significantly lower than pre-2008 downturn pricing levels, and we do not
see material pricing cuts ahead
• We expect cost moderation to accompany growth moderation, which makes us believe
there is upside to margins in FY13F.
We expect moderation in FY13F revenue growth in tier 1 IT companies as short-term
decision making and macro uncertainties lead to clients’ being conservative on FY13
budgets. We look for this to impact growth from 4QFY12F onwards. The other casualty,
in our view, would be expectations of pricing increases in FY13F, which we think might
not be possible now as the crisis has come too close to budgeting for the next year and
discretionary demand could get hit. We expect this slowdown to start being reflected in
FY13 revenue growth for tier 1 Indian IT companies, and we look for low-teen growth in
FY13F vs an average of 22% growth in FY12F.
However, we expect positive developments on margins as companies start to react by
curtailing their hiring plans, perking up utilisation, moderating wage inflation to singledigit
levels or lower in FY13F (vs our earlier expectations of double-digit increases), and
the possibility of push-back in wage hikes from 1Q by at least a quarter or two if demand
were to moderate. In our view, this should cushion the impact of volume declines on
earnings to some extent. We expect FY13F margins to be flat or better than FY12F
margins. We note that continuation of the recent rupee depreciation moves would likely
be an upside trigger for margins.
We have relatively greater confidence in companies that are 1) market share gainfocused;
2) have low client concentration/BFSI and European exposure; 3) have better
operational scope to cushion the potential impact of a growth slowdown; and 4) show
lower future growth expectations being built into valuations. On these parameters, we
like Infosys and HCL Tech (top pick), where we see 15-30% upside from current levels.
We remain cautious on Cognizant and TCS, given their 1) high BFSI and/or European
exposure and high client concentration; and 2) significantly higher future growth
expectations being built in, which on a disappointment could potentially lead to sharp
stock corrections from current levels. Wipro remains our least-preferred stock in tier 1 IT
as we see the company as structurally weak, and we believe its efforts to revive growth
would receive a set back in a scenario of growth moderation. We upgrade Patni to
Neutral from Reduce, as we see its risk-reward turning incrementally positive, as a result
of the stock correcting by 39% YTD (vs 19% in the Nifty).
Risk to our sector call is rupee appreciation beyond assumed levels or breakage of
pricing discipline leading to pricing declines in FY13F. Upside sector risks to our
estimates are return of macro stability and continuation of current rupee depreciation
trends (with our FY13F estimates currently factoring in USD-INR rate of 45).
Earnings estimates revised up on rupee depreciation
We are revising our FY12F estimates for companies under coverage assuming average
USD-INR rates for 2Q and changing our assumptions for 3Q and 4Q to a USD-INR rate
of 46 and 45 (vs 44.5 earlier). We revise our FY13F USD-INR assumptions to 45 (from
44 earlier). We raise our target prices marginally for Infosys, TCS, Wipro and Patni by 2-
3%.
Scenario analysis: What if the US and
Europe slip back into recession?
As the markets have been signaling that risks to our baseline forecasts are on the
downside, our global economics team have considered a bear case economic scenario,
most obviously triggered by a market meltdown, but the fragile state of the advanced
economies leaves them vulnerable to unforeseen shocks or policy errors. For details,
see Global Weekly Economic Monitor, 12 August 2011, and Global market turbulence:
Implications for Asia, 9 August 2011.
The bear case scenario assumes:
• The US and Euro area slip back into recession, with US GDP averaging -1% saar in
2H11 and Euro GDP averaging -3% before recovering to around 2% growth in 2012.
• The CRB commodity price index falls 15% between now and year-end, but starts rising
back again through 2012 reaching current levels by end-2012.
If there is a market meltdown and recessions in the US and euro area, we have no doubt
that initially many economies in the region would be hit hard again in an echo of the
global financial crisis, as non-linear effects start to kick in, notably financial decelerator
effects, multiplier effects of weakening exports on domestic capex and jobs, and capital
flight. However, less disturbing this time around are the two factors that there is less
leverage in the financial system (less room for capital flight) and less chance of Asian
trade finance drying up, as the world’s central banks have most likely learnt the need to
provide ample USD liquidity through FX swap arrangements.
In this scenario, we find Hong Kong, Singapore, Malaysia and Taiwan to be among the
most vulnerable. But, as in 2009, we would expect that, over time, powerful tailwinds
would develop, allowing Asia to bounce back before other regions. These tailwinds
include a likely further decline in commodity prices and the ample room Asia has to ease
monetary and fiscal policies – more so than any other region. In our bear case scenario,
we would expect the Fed to resort to further quantitative easing, which once again would
likely precipitate strong net capital inflows into Asia, attracted by stronger growth,
superior fundamentals and higher interest rates relative to other regions.
What if things get even worse than we can foresee? Although our global economics
team does not see such a situation as plausible at the moment, they have run an
extreme-case scenario analysis to provide some perspective. This extreme scenario
assumes:
• US GDP averaging about -4% saar in 2H11 and Euro GDP averaging -6.5% before
recovering to around 1% growth in 2012.
• CRB commodity price index falls 40% between now and year-end, and stays at the
lower level through 2012.
The table below summarises both the official bear case and the hypothetical extreme
case scenarios.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Action: Prefer HCL Tech followed by Infosys
HCLT is our top pick within tier 1 IT on expectations of strong revenue
growth (5.4% q-q), lower EBITDA margin declines despite wage hikes, on
rupee depreciation and reasonable valuation comfort. At Infosys, we
expect a cut in revenue growth guidance and think any fall in the stock
should be used as an opportunity to add positions as we believe prices
already factor in a moderation in growth. We remain cautious on TCS and
CTSH on high BFSI/Europe/Client concentration exposure and lower
valuation comfort. Wipro remains our least-preferred stock in tier 1 IT.
Catalyst: Stability in macroeconomic conditions and continuation of
rupee depreciation trends would be potential positive triggers for IT
stocks.
No material revenue growth moderation in 2Q
We expect USD revenue growth of 3.4-6.5% q-q across tier 1 IT
companies, with CTSH and TCS leading on revenue growth. Infosys and
Wipro should be in line with guidance. The impact of the recent economic
slowdown is unlikely to be visible in results this quarter, in our view.
Likely FY12F revenue guidance cut at Infosys, EPS guidance raise
The first impact of the slowdown, in our view, would be with Infosys cutting
its FY12F revenue growth guidance to 16-18% (from 18-20%) as
discretionary demand tapers and cross-currency impacts hurt USD
revenue growth. However, we see EPS guidance being raised to around
INR135 (from INR128-130) largely driven by rupee depreciation and
optimized hiring towards year-end.
Valuation: EPS up on rupee depreciation; upgrade Patni to Neutral
We revised our EPS estimates higher as we factor a new FY13F USD-INR
rate of 45 vs 44 earlier. We upgrade Patni to Neutral from Reduce.
Strong quarter: no material revenue
growth moderation, positive rupee
depreciation impact
We expect a strong 2QFY12 performance from tier 1 IT companies driven by a likely
limited impact from current economic uncertainty on demand and an expected significant
positive impact from recent rupee depreciation vs the USD (2.5% q-q on the average for
2QFY12 and 9.6% q-q on the closing rate). We expect the impact of the slowdown to
start to be visible in the 3QFY12 commentaries of managements as they get greater
clarity on FY13 budgets and the repercussions of the slowdown start to be seen in
4QFY12F in terms of revenue growth. Our FY13F estimates for tier 1 IT companies build
low-teen revenue growths vs an average of 22% growth in FY12F.
Infosys is likely to benefit most from rupee depreciation, in our view, compared with TCS
and Wipro, on account of Infosys’ lower hedging levels. We estimate Infosys will beat its
2Q EPS guidance by ~20%.
USD revenue growth in 2Q FY12F is likely to be in the range of 3.4-6.5% for tier 1
players (including Cognizant), on our estimates, partly moderated by a ~40-70bp impact
of adverse cross-currency moves. We expect volume growth to be in the range of 4-7%,
with stable pricing. In our view, Cognizant, TCS and HCL Tech will do better on revenue
growth vs the other tier 1 companies while Wipro could continuing to lag. We look for
Infosys’ revenue growth to be in line with its guidance for the quarter.
Margins are likely to look up on rupee depreciation, with Infosys expected to gain the
most, in our view. TCS’s margin positives on rupee depreciation will likely be offset
somewhat by a ~70-80bp impact of promotions, while Wipro and HCL Tech’s margins
are expected to be depressed by wage inflation, cushioned to some extent by rupee
depreciation. Typically, the sensitivity of the margins to 1% rupee depreciation is on the
order of 40-50bps for Indian IT companies, based on our calculations.
Earnings are likely to be a mixed bag depending on hedging levels and timing of wage
hikes. We expect Infosys to post the best q-q EPS growth of 18.6%.
Key things to watch out for
• Infosys guidance: A downward revision of its FY12F USD revenue growth guidance to
16-18% (vs 18-20% earlier) looks likely to us on 1) adverse cross-currency impact on
USD revenues; and 2) growth moderation, especially in discretionary segments with tail
revenues of consulting engagements likely to be deferred. We expect EPS guidance to
be raised to around INR135 (from INR128-130 earlier) primarily on the back of rupee
depreciation and hiring optimization towards the end of the year. We believe the market
would react negatively if Infosys’ EPS guidance falls short of INR135.
• Overall demand commentary: We expect status quo in terms of demand commentaries
by companies as: 1) a look into FY13F budgets will likely be limited; and 2) clients
would have had not enough time to react to the recent macro-economic developments.
We see the impact on demand largely starting to be reflected in commentaries in
3QFY12F and in revenues from 4QFY12F onwards.
• Package implementation, Europe and BFSI demand: These are the first segments in
our view likely to be impacted by the current economic deterioration; we expect growth
and outlooks in these segments will be keenly watched.
• Infrastructure management services (IMS) demand and corresponding deal flow: We
recommend watching for growth in IMS and deal commentary by TCS and HCL Tech in
particular on re-bid deals, to corroborate our view that re-bid/cost or efficiency-focussed
deals are unlikely to be pushed back.
• Hiring commentary: Any curtailments in hiring and improvement in utilization
expectations should be taken as corroboration of our view that revenue moderation will
likely lead to cost moderation.
Infosys guidance cut – sentimentally negative, but in the price
We expect Infosys to reduce FY12F USD revenue growth guidance from 18-20% to 16-
18% on account of 1) cross-currency impact being negative on USD revenue growth;
and 2) growth moderation, especially in discretionary demand as tail projects post
consulting engagements start to get deferred. The pick-up in discretionary demand in
2HFY12 was a key assumption in Infosys’ back-ended growth guidance for FY12F, in
our view.
We, however, expect the company to raise its EPS guidance to around INR135 (from
INR128-130 earlier) and its EBITDA margin decline guidance to be revised to 200bps
(from a 250bp decline earlier) on account of 1) rupee depreciation; and 2) hiring
optimization going into 4QFY12F – especially in terms of laterals. Infosys had earlier
indicated that it would be hiring 45,000 people in FY12F. This number, in our view, was
~3-4% higher than what their top-end revenue growth guidance of 20% implied. This
would now be optimized for the lower growth expectations. We do not expect the
company to lower its fresher hiring targets.
We see this development as a sentimental negative, but do not see a material price
impact of this move as our expectations, as well as consensus, already build in no
outperformance vs guidance. Any adverse stock reactions on account of this move
should be used to add positions, in our view.
View unchanged – Demand moderation likely to be less
severe than last time around, Prefer HCL Tech/Infosys
Our view remains that this downturn is not as severe as the post-Lehman crisis
downturn, with the key reasons being:
• Fundamental positioning of Indian IT players is much stronger now than during the
previous downturn, with participation rates in deals increasing.
• Clients are in much better shape and are not facing an existential crisis – hence while
we see cuts, we do not expect them to be as sharp as those during the last downturn.
Moreover, we have not seen overspending on technology in the recent past for it to be
cut materially.
• Pricing is still significantly lower than pre-2008 downturn pricing levels, and we do not
see material pricing cuts ahead
• We expect cost moderation to accompany growth moderation, which makes us believe
there is upside to margins in FY13F.
We expect moderation in FY13F revenue growth in tier 1 IT companies as short-term
decision making and macro uncertainties lead to clients’ being conservative on FY13
budgets. We look for this to impact growth from 4QFY12F onwards. The other casualty,
in our view, would be expectations of pricing increases in FY13F, which we think might
not be possible now as the crisis has come too close to budgeting for the next year and
discretionary demand could get hit. We expect this slowdown to start being reflected in
FY13 revenue growth for tier 1 Indian IT companies, and we look for low-teen growth in
FY13F vs an average of 22% growth in FY12F.
However, we expect positive developments on margins as companies start to react by
curtailing their hiring plans, perking up utilisation, moderating wage inflation to singledigit
levels or lower in FY13F (vs our earlier expectations of double-digit increases), and
the possibility of push-back in wage hikes from 1Q by at least a quarter or two if demand
were to moderate. In our view, this should cushion the impact of volume declines on
earnings to some extent. We expect FY13F margins to be flat or better than FY12F
margins. We note that continuation of the recent rupee depreciation moves would likely
be an upside trigger for margins.
We have relatively greater confidence in companies that are 1) market share gainfocused;
2) have low client concentration/BFSI and European exposure; 3) have better
operational scope to cushion the potential impact of a growth slowdown; and 4) show
lower future growth expectations being built into valuations. On these parameters, we
like Infosys and HCL Tech (top pick), where we see 15-30% upside from current levels.
We remain cautious on Cognizant and TCS, given their 1) high BFSI and/or European
exposure and high client concentration; and 2) significantly higher future growth
expectations being built in, which on a disappointment could potentially lead to sharp
stock corrections from current levels. Wipro remains our least-preferred stock in tier 1 IT
as we see the company as structurally weak, and we believe its efforts to revive growth
would receive a set back in a scenario of growth moderation. We upgrade Patni to
Neutral from Reduce, as we see its risk-reward turning incrementally positive, as a result
of the stock correcting by 39% YTD (vs 19% in the Nifty).
Risk to our sector call is rupee appreciation beyond assumed levels or breakage of
pricing discipline leading to pricing declines in FY13F. Upside sector risks to our
estimates are return of macro stability and continuation of current rupee depreciation
trends (with our FY13F estimates currently factoring in USD-INR rate of 45).
Earnings estimates revised up on rupee depreciation
We are revising our FY12F estimates for companies under coverage assuming average
USD-INR rates for 2Q and changing our assumptions for 3Q and 4Q to a USD-INR rate
of 46 and 45 (vs 44.5 earlier). We revise our FY13F USD-INR assumptions to 45 (from
44 earlier). We raise our target prices marginally for Infosys, TCS, Wipro and Patni by 2-
3%.
Scenario analysis: What if the US and
Europe slip back into recession?
As the markets have been signaling that risks to our baseline forecasts are on the
downside, our global economics team have considered a bear case economic scenario,
most obviously triggered by a market meltdown, but the fragile state of the advanced
economies leaves them vulnerable to unforeseen shocks or policy errors. For details,
see Global Weekly Economic Monitor, 12 August 2011, and Global market turbulence:
Implications for Asia, 9 August 2011.
The bear case scenario assumes:
• The US and Euro area slip back into recession, with US GDP averaging -1% saar in
2H11 and Euro GDP averaging -3% before recovering to around 2% growth in 2012.
• The CRB commodity price index falls 15% between now and year-end, but starts rising
back again through 2012 reaching current levels by end-2012.
If there is a market meltdown and recessions in the US and euro area, we have no doubt
that initially many economies in the region would be hit hard again in an echo of the
global financial crisis, as non-linear effects start to kick in, notably financial decelerator
effects, multiplier effects of weakening exports on domestic capex and jobs, and capital
flight. However, less disturbing this time around are the two factors that there is less
leverage in the financial system (less room for capital flight) and less chance of Asian
trade finance drying up, as the world’s central banks have most likely learnt the need to
provide ample USD liquidity through FX swap arrangements.
In this scenario, we find Hong Kong, Singapore, Malaysia and Taiwan to be among the
most vulnerable. But, as in 2009, we would expect that, over time, powerful tailwinds
would develop, allowing Asia to bounce back before other regions. These tailwinds
include a likely further decline in commodity prices and the ample room Asia has to ease
monetary and fiscal policies – more so than any other region. In our bear case scenario,
we would expect the Fed to resort to further quantitative easing, which once again would
likely precipitate strong net capital inflows into Asia, attracted by stronger growth,
superior fundamentals and higher interest rates relative to other regions.
What if things get even worse than we can foresee? Although our global economics
team does not see such a situation as plausible at the moment, they have run an
extreme-case scenario analysis to provide some perspective. This extreme scenario
assumes:
• US GDP averaging about -4% saar in 2H11 and Euro GDP averaging -6.5% before
recovering to around 1% growth in 2012.
• CRB commodity price index falls 40% between now and year-end, and stays at the
lower level through 2012.
The table below summarises both the official bear case and the hypothetical extreme
case scenarios.
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