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􀂃 Downgrade to DETERIORATING, six stocks to REDUCE on large EPS cuts
􀂃 Stocks are yet to reflect prolonged macro weakness or likely recession
􀂃 Adverse macro data points that could affect 60-75% of revenue emerge
􀂃 Strong relationship between Indian IT growth and macro variables
Yes, things could get worse
Stocks should be available cheaper in a few months
We downgrade the India IT services sector to DETERIORATING and six stocks
(Infosys, TCS, Wipro, HCL Tech, MindTree and Persistent) to REDUCE. Despite
these stocks declining by an average of 13% (vs a 7% drop of the Sensex) in
August alone, we think they are yet to reflect a likely prolonged anaemic macro
growth scenario and the 50% chance of a US recession that our economics team
forecasts. Moreover, we are yet to see material consensus downgrades since the
macro data started worsening. We believe that even two-three quarters of flat-tomuted
q-q revenue growth over FY12-13 (vs Street expectations of a 4-5%
average) for our covered companies could lead to large EPS cuts. We lower our
FY13 EPS estimates by 12-31% for the six stocks and to 10-30% below Street.
Adverse macro across verticals, micro should catch up
Significant adverse macro data has recently emerged that could have a bearing
on verticals such as financials, manufacturing and retail (61-74% of revenue for
large-cap Indian IT companies). These include a fall in the US ISM and consumer
confidence data to recessionary levels, and over 100,000 jobs cuts announced in
financial services. Further, continuing weakness in telecom spending suggests
likely lower visibility for about 80% of revenue. Moreover, downward revisions to
historical US GDP data bring into question recent above-trend India IT growth.
Meanwhile, as per our discussions with companies and contacts, while ongoing
projects have not been affected, there is nervousness about future quarters.
Quantifying the impact of weak macro on Indian IT growth
Our regression analysis of historical Indian IT services growth versus US GDP
growth and a base effect variable suggests a fairly strong relationship (adjusted
R-square of 0.58). Therefore, over the next few quarters, not only should Indian IT
growth slow due to a higher base from continued headcount dependence, but
weaker macro data should only worsen the situation. In fact, our exercise
suggests that another recession of a similar magnitude as 2008-09 could result in
worse q-q revenue dips for Indian IT players than they saw in FY09.
Valuation: Revisiting our DCF charts
Our DCF models suggest stocks are trading at close to their base-case fair values
assuming long-term average risk levels persist. However, in 2008, stocks fell to as
much as 40-65% below their fair values, and we believe such a situation could
repeat if demand worsens. For investors looking for sector exposure, we
recommend higher-margin players (TCS, Infosys) as they are likely to better
protect their earnings. The risk to our call is unexpected USD/INR depreciation.
Stocks should be available cheaper in a few months
We are downgrading the Indian IT services sector to DETERIORATING and six stocks
(Infosys, TCS, Wipro, HCL Tech, MindTree and Persistent) to REDUCE. Despite an
average of 13% decline of large-cap IT stocks in August alone (vs a 7% drop of the
Sensex), we think stock prices are yet to reflect either a likely prolonged anaemic macro
growth scenario nor the 50% probability of a US recession that our economics team
believes is the case.
The recent fall in stocks may lead investors to believe that value is emerging, but we
think stocks will be available cheaper over the next few months because we are likely to
see deteriorating news flow. Moreover, we are yet to see any material consensus EPS
downgrades since the data started worsening recently.
We believe even two-three quarters of flat-to-muted q-q revenue growth over FY12-13
for our coverage companies could lead to significant EPS cuts on a constant currency
basis. Current Bloomberg consensus projections imply more than 5% average q-q
revenue growth for the remainder of FY12 and over 4% for FY13 for the four large-cap
stocks (TCS, Infosys, Wipro and HCL Tech).
Our own FY13 EPS estimates are now lower by 12-31% for the six stocks and are
about 10-30% below consensus. We have also reduced our target prices accordingly.
Adverse macro developments in each of the largest verticals
As is now widely known, there are three macro worries to contend with, all of which
could worsen the outlook for IT services spending over the next few quarters: 1)
deteriorating US and Europe growth data, 2) the US sovereign downgrade, and, 3)
continued escalation of the European debt crisis.
Over the past fortnight or so, significant macro data has come to light that signals a
drop in q-q growth rates for Indian IT companies across verticals, and more specifically
for financials, manufacturing and retail (61-74% of revenue for large-cap Indian IT
companies). Add to this, already continuing weakness in the telecom vertical suggests
likely lower visibility in areas that contribute about 80% of revenue for Indian IT services
players.
Downward GDP revisions bring into question recent above-trend India IT growth
Recent revisions to US GDP data suggest that the economy was in a deeper recession
and the recovery was more lacklustre than previously believed. Furthermore, the US
economy grew at only about 1% annualized in 1H11. This brings into question the
above-trend growth that Indian IT companies have seen over the past few quarters
(given the economy was worse off relative to IT services spending levels), and it is likely
clients will re-look at their IT budgets given the new economic realities.
Furthermore, BNPP economists now see 50-50 chance of recession
As per our economists (When All Else Fails, 9 August 2011), the combination of
markdowns to the global economic outlook and a growing sense that policymakers are
no longer able or willing to offer support have led them to believe that there is 50%
probability of a recession over the next six months. This is in contrast to their earlier
view that the world was going through a soft patch and that growth would recover from
3Q11.
US ISM declines consistent with a recessionary situation
Meanwhile, the continued decline in the US ISM survey data suggests that the
economy has weakened further moving into 3Q11. As per our economists, the abrupt
nature of the change in the index is usually associated with recession (Macro Monday,
8 August 2011).
Consumer sentiment at lower than 2008 crisis levels
The Reuters/University of Michigan consumer sentiment index fell sharply to 54.9 in
mid-August from 63.7 in late July, and was lower than the crisis level of November
2008.
Meanwhile, several financial institutions have announced job cuts
In addition, as per Bloomberg data, several financial institutions (mostly in Europe) have
announced more than 100,000 job cuts in 2011 to cut costs.
Much of the growth in recent years for Indian IT companies has come from market
share gains because of the much improved scale, better client relationships from
beefed up front ends, and newer service lines such as infrastructure services and
verticals such as energy, utilities and healthcare. We also believe that they are probably
better prepared now than in 2008 to face a recessionary situation.
However, these factors do not take away from the fact that in the event of an overall
slowdown, they would not stay unaffected.
Ground level and macro data should eventually converge
No negatives from two CEOs on the road, but nervousness on the ground now
Our discussions with companies, industry contacts and recruitment agencies over the
past week suggest that companies are still trying to assess the likely impact of the
recent events. In fact, we had two industry CEOs (MindTree and Persistent Systems)
on the road with us in late-July for investor meetings, and neither of them had anything
negative to comment on demand. This is consistent with our checks that suggest that
ongoing IT services projects have not been impacted yet, but the feeling on-the-ground
is nervous about future quarters (particularly from December 2011 quarter).
Recently strong software and services results point to high near-term visibility
Meanwhile, company results that have come in recently (IBM, SAP, Cognizant and
others) present a bullish near-term demand picture with several of the companies
raising their full-year outlook.
But demand could worsen from December 2011
For Indian IT services companies, we believe previous projections of a 2HFY12 or
1HFY13 pick-up need a rethink given the new macro data at hand. All these data points
suggest high near-term visibility, but a relatively cloudy outlook from late FY12.
Quantifying the impact of weak macro on Indian IT growth
In boom times, clients offshore more and in bad times, they offshore less
There have been some arguments that in recessionary times, clients increase
outsourcing spending to cut costs. However, we note that over the past few years,
Indian IT revenue growth has closely tracked US GDP growth.
In fact, as we highlighted in our note No growth if top customers don’t expand, 26
November 2008, historically, IT offshoring growth has been closely correlated with the
revenue growth of the largest 100-150 accounts (and more so the largest 50 accounts
which contribute over 50% of the revenue). Hence, Indian IT companies are a direct
play on overall macroeconomic activity. In simple terms, in boom times, clients offshore
more and, in bad times, they offshore less.
Indian IT trend growth should decline due to weaker macro and higher base …
Our regression analysis of historical Indian IT services q-q growth versus US GDP
growth and a variable to measure the base effect for Indian companies (absolute
revenue of Infosys used as a proxy given clean historical data) suggests a fairly strong
relationship between the variables (adjusted R-square of 0.58).
In other words, over the next few quarters, not only should the trend growth for Indian IT
companies decline due to a higher base because of continued headcount dependence
(as we have noted previously in our notes Don't fix it if it ain't broken, 28 February 2011
and The time is now, 30 March 2011), but weaker macro data should only worsen the
situation.
Based on this analysis, it appears to us that the recent above-trend average q-q growth
for the largest four Indian IT companies is unlikely to be sustained, and may have at
least been partly driven by clients expecting that the macro situation would improve
rather than worsen.
Our theoretical exercise also suggests that the about 6.3% q-q average growth seen by
large-cap Indian IT players in FY11 could drop to 3.5-4.0% in FY12 (similar to FY10
levels) and further drop to 2.0-3.0% in FY13 if a recession sets in or if prolonged
anaemic macro growth becomes a reality. In fact, if a recession of a similar magnitude
as 2008 comes through, we believe Indian IT services companies could see worse q-q
revenue dips than they saw in FY09.
… and is reflected in our estimate cuts
We revise our estimates to factor in a 50% probability of recession that our economists
now believe is the case. Therefore we now see a flattish q-q June 2012 quarter and
relatively mute quarters on either side (i.e, March 2012 and September 2012).
Even though we believe Indian IT companies may be better prepared now than in 2008
for such a situation, we think it is unlikely that clients will not ask for lower pricing in
such a situation. Therefore, on a constant-currency basis, we see EBIT margin heading
lower into FY13.
As a result, while there are relatively small revenue and EPS cuts for our coverage for
FY12E, there are significant (9-16% revenue and 12-31% EPS) cuts for FY13E (see
Exhibit 1).
Companies with higher EBIT margins such as TCS and Infosys have smaller EPS cuts
and therefore remain relatively better investment options in such an environment, in our
view.
Risks to our call: Lessons from 2008-09
We draw parallels with 2008-09 when large-cap stocks fell 40-65% from their peaks to
troughs between September 2008 and March 2009. FY10 P/E multiples went down 30-
50% for the large caps, while those of some mid-cap companies fell more to
fundamentally unjustifiable levels. Consensus FY10 (and not so much FY09) EPS
estimates were cut 11-30% for large-cap stocks.
However, in hindsight (now that we have actual FY09-11 EPS numbers), it turned out
that such EPS cuts were not entirely deserved because: 1) the USD/INR appreciated
significantly through the period and aided earnings, and to a lesser extent, 2) the
recovery happened faster-than-expected, and 3) companies such as TCS and Wipro
ran stringent margin programmes and improved margins.
Between the June 2008 and December 2009 quarters, the USD/INR depreciated by as
much as 11% on a quarterly average basis, giving Indian IT companies a 500-550bps
EBIT margin buffer. Between these quarters, the largest four companies reported an
average 240bp EBIT margin improvement. Therefore, the USD/INR depreciation was
the single biggest factor why consensus downgrades proved too aggressive.
We believe the same three factors present risks to our call. Our models are built on a
constant-currency basis (using the current approximately USD/INR45.5 rate), so do not
factor in the unexpected currency swings.
Valuations: Revisiting our DCF charts and past lessons
Over the next few months, we expect Indian IT services stocks to decline on macro
uncertainty and advise investors to wait for better prices to enter the stocks.
To set our target prices, we revisit our historical DCF models that compare “what was”
vs “what should have been” and, in our view, are useful visual aids to identify buy/sell
opportunities for the long term. As part of this exercise, we back-calculate the historical
DCF fair values of stocks using reported numbers. In other words, these are the prices
a stock should have traded at if investors had perfect information about future earnings.
Given the cut in our FY12-14 forecasts, the bull, base and bear case lines see a
downward parallel shift. The other adjustment to our DCF models is a reduction in the
medium-term growth rate from 12% to 10% because of increased cyclicality in the
industry that was not so apparent earlier
At current prices, stocks are trading at close to their base-case fair values on our
estimates, but at historical long-term average risk premia levels (i.e., no change to
beta). However, we believe increased macro uncertainty and likely sub-par EPS growth
in FY13 could lead to investors reassessing the risk premia for the stocks until such a
situation persists. As a result, we believe stocks could trade below what our long-term
DCF models suggest.
In 2008, we note that large-cap Indian IT stocks went to levels that were about 40-65%
(and about 25-60% on an average during May 2008 to March 2009) below what our
long-term DCF fair values would have suggested. Using these for direction, we set our
target prices 20-25% below what our long-term DCF models imply.
TCS has significantly re-rated over the past couple of years due to improving
operations, stable management and by consistently beating consensus forecasts. As a
result, we believe the discount that it traded at in 2008-09 to our implied DCF
calculations was at an exaggerated level (recall our DCF charts are built with the benefit
of hindsight).
For investors looking to take exposure to the sector, we would recommend highermargin
companies such as TCS and Infosys as they are likely to better protect their
earnings in the event of price cuts. Specifically, we would prefer TCS given its scale,
stable management and lean organization structure.
