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Sector downgrade
We are downgrading our sector recommendation for Indian IT from
Neutral to Underweight as we watch the margin of safety in Indian IT
stocks recede. We see three extant islands of optimism being tested in
Indian techs in coming months. 1) 20%+ growth is achievable in
FY13/14 for Tier-1 vendors. 2) Visa issues are unlikely to alter business
prospects. 3) Valuations of Tier-1 techs are not at risk. We expect the
upcoming months to be a downward inflexion point for trends in all three
parameters driving stock prices down, though June quarter results are
unlikely to show any material proof points. Indian IT holds little promise
of sustainable absolute returns hereon. We are downgrading TCS and
Infosys to Underperform and have no positive ratings in the sector now.
Three questions before Indian IT
q Is 20%+ growth achievable in FY13/14? While demand trajectory is good for now,
it has flat-lined after the surge last year, posing risks to street revenue forecasts
for future years. Also, CLSA’s strategist Russell Napier’s forecast of a rise in US
treasury yields to potentially deflationary levels could impact growth prospects.
q How much is the visa issue hurting? Newsflow on the visa front continues to be
negative across countries with rejection rates in US currently running at almost
40%, up from 5%, 18 months back. We see the visa issue fundamentally altering
the business model for Indian techs with its operational (inability to staff projects
on time) as well as commercial (higher visa/subcontracting costs) impact.
q Can valuations of Tier-1 techs sustain? Valuations of Tier-1 techs need to contend
with lower (mid to high teens) revenue/EPS Cagr outlook, as well as the challenges
from business transformation that lie ahead. The risk of a potential IT spending
slowdown further raises the spectre of valuation compression.
Where is the disconnect with bullish management commentary?
q Bullish management commentary is comforting, but perhaps not actionable given
the already high street expectations (20%+ growth for tier-1 techs over next few
years) and the history of the sector’s major moves (2001, 2003 and 2007), where
company talk remained positive well into the demand flux.
q Moreover, while confidence on near-term demand remains strong across vendors,
commentary on FY12 growth achievement has gradually shifted from the confident
certainty earlier this year to hopes of a 2H pick-up.
q Past trends indicate that expectations of back-ended growth have seldom borne
fruit and have been de-railed due to a range of unanticipated causes. We believe
that the current macro overhang could likely cause an encore later this year.
See absolute downsides in all stocks
q As our checks point to moderating growth, within a more challenging business
(visas + need for non-linearity) and cost (wage hikes + local hiring) dynamic, we
see absolute downsides for tech stocks, especially over the short to medium term.
q While a major upgrade of the current earnings trajectory is a necessary trigger for
stock performance, even minor EPS downgrades could have a disproportionate
impact on valuations and stock price. As such, investment in IT stocks has an
unfavourable risk-reward equation for now.
q We now have a negative rating on all stocks in our Indian IT coverage list.
Stock-specific issues
q TCS: Within the sector, company credentials remain very strong but the stock
needs to contend with high expectations and over-ownership.
q Infosys: FY12 hopes have moderated but FY13 expectations remain elevated.
Internal issues seem sorted but an unfavourable macro will likely play spoilsport.
q Wipro: Achievement of street expectations is contingent on a 2HFY12 pick-up by
which time we expect demand environment to soften. Internal issues will take time
to sort out limiting financial performance c.f. peers.
q HCL Tech: Aggression in the market could drive industry-leading growth but at the
cost of margin impairment. High expectations leave little room for disappointment.
Visit http://indiaer.blogspot.com/ for complete details �� ��
Sector downgrade
We are downgrading our sector recommendation for Indian IT from
Neutral to Underweight as we watch the margin of safety in Indian IT
stocks recede. We see three extant islands of optimism being tested in
Indian techs in coming months. 1) 20%+ growth is achievable in
FY13/14 for Tier-1 vendors. 2) Visa issues are unlikely to alter business
prospects. 3) Valuations of Tier-1 techs are not at risk. We expect the
upcoming months to be a downward inflexion point for trends in all three
parameters driving stock prices down, though June quarter results are
unlikely to show any material proof points. Indian IT holds little promise
of sustainable absolute returns hereon. We are downgrading TCS and
Infosys to Underperform and have no positive ratings in the sector now.
Three questions before Indian IT
q Is 20%+ growth achievable in FY13/14? While demand trajectory is good for now,
it has flat-lined after the surge last year, posing risks to street revenue forecasts
for future years. Also, CLSA’s strategist Russell Napier’s forecast of a rise in US
treasury yields to potentially deflationary levels could impact growth prospects.
q How much is the visa issue hurting? Newsflow on the visa front continues to be
negative across countries with rejection rates in US currently running at almost
40%, up from 5%, 18 months back. We see the visa issue fundamentally altering
the business model for Indian techs with its operational (inability to staff projects
on time) as well as commercial (higher visa/subcontracting costs) impact.
q Can valuations of Tier-1 techs sustain? Valuations of Tier-1 techs need to contend
with lower (mid to high teens) revenue/EPS Cagr outlook, as well as the challenges
from business transformation that lie ahead. The risk of a potential IT spending
slowdown further raises the spectre of valuation compression.
Where is the disconnect with bullish management commentary?
q Bullish management commentary is comforting, but perhaps not actionable given
the already high street expectations (20%+ growth for tier-1 techs over next few
years) and the history of the sector’s major moves (2001, 2003 and 2007), where
company talk remained positive well into the demand flux.
q Moreover, while confidence on near-term demand remains strong across vendors,
commentary on FY12 growth achievement has gradually shifted from the confident
certainty earlier this year to hopes of a 2H pick-up.
q Past trends indicate that expectations of back-ended growth have seldom borne
fruit and have been de-railed due to a range of unanticipated causes. We believe
that the current macro overhang could likely cause an encore later this year.
See absolute downsides in all stocks
q As our checks point to moderating growth, within a more challenging business
(visas + need for non-linearity) and cost (wage hikes + local hiring) dynamic, we
see absolute downsides for tech stocks, especially over the short to medium term.
q While a major upgrade of the current earnings trajectory is a necessary trigger for
stock performance, even minor EPS downgrades could have a disproportionate
impact on valuations and stock price. As such, investment in IT stocks has an
unfavourable risk-reward equation for now.
q We now have a negative rating on all stocks in our Indian IT coverage list.
Stock-specific issues
q TCS: Within the sector, company credentials remain very strong but the stock
needs to contend with high expectations and over-ownership.
q Infosys: FY12 hopes have moderated but FY13 expectations remain elevated.
Internal issues seem sorted but an unfavourable macro will likely play spoilsport.
q Wipro: Achievement of street expectations is contingent on a 2HFY12 pick-up by
which time we expect demand environment to soften. Internal issues will take time
to sort out limiting financial performance c.f. peers.
q HCL Tech: Aggression in the market could drive industry-leading growth but at the
cost of margin impairment. High expectations leave little room for disappointment.