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The relative stability of consensus forecasts of S&P500 earnings in 2011
suggests that the risks are lower compared to 2008. Key sectors in the
US, such as Financials, have shown greater resilience, while the changing
attitude towards outsourcing by European companies may provide an
opportunity. Indian firms are likely to continue adding to their global
market share, as they benefit from secular trends such as a rise in
offshoring in SI and Consulting. Contrary to general perception, the
outperformance of the CNXIT Index in late 2011 may not be largely
driven by the INR decline, but is attributable more to the relative
stability of global demand. The potentially stronger earnings growth is
likely to support the premium valuation of the CNXIT Index relative to
the Nifty with secular trends favoring Tier‐I firms. Resume coverage on
TCS (Add); initiate coverage on HCLT (Buy).
Opportunities from the global crisis may outweigh the risks this time
The relative stability of consensus forecasts in 2011 suggests that the risks are
lower compared to 2008. Earnings forecasts of the S&P500 have declined by just
4.0% in 2011, well below the 23.5% erosion in 2008. Key sectors such as
Financials and Manufacturing, that drive revenues of the Indian IT industry, have
shown greater resilience. Consensus forecasts of earnings of the FTSE and Stoxx
also suggest a better outlook for Europe than in 2008. The changing attitude
towards outsourcing by European firms may provide an opportunity for Indian IT.
Share of global pie likely to expand even further
The 2008‐2009 recession had seen Indian IT firms add an estimated 2% to their
global market share against global peers. The market share is likely to expand
even further as Indian firms continue to benefit from secular trends such as
vendor consolidation and deal churn, owing to their large scale and diverse
offerings. Indian vendors are well‐poised to gain from a rise in offshoring in
System Integration (SI) and Consulting. A tilt in revenue mix towards non‐linear
pricing models would also help sustain pricing and overcome cost pressures.
INR weakness only partly drives rally, business outlook a stronger force
The outperformance in late 2011 may not have been largely driven by the INR
decline—as seen from the stability of FY12 EPS forecasts. Moreover, the
comparable situation in 2008 indicates that a weak INR cannot offset the
weakness in ultimate demand. Performance of the CNXIT Index is attributable
more to the relative stability of global demand and greater opportunities.
Premium valuation has solid grounds; still room for upside
2011 saw the CNXIT Index regain its premium over the Nifty, yet it is at a
discount to its two‐year mean PEG. The relative stability of earnings drivers and
potentially stronger earnings growth are likely to support the premium, with
secular trends in offshoring favoring Tier‐I firms.
Resume coverage on TCS and initiate coverage on HCLT
We resume coverage on TCS (Add) with a Dec12 target of INR1,304, and initiate
coverage on HCLT (Buy) with a Dec12 target of INR500. Key risks are INR
volatility and a worsening global economy.
The current global business environment poses far lower risk to the Indian IT industry compared with that triggered by
the insolvency of several mega financial entities in 2008. Earnings forecasts of S&P500 companies in the US, the major
market for Indian IT, have declined by barely 4.0%, well below the 23.5% erosion in forecasts in 2008. Key US sectors
such as Financials, Manufacturing, Energy and Utilities are in much better shape today than in 2008. The 2008‐2009
recession had seen Indian firms add an estimated 2% to their global market share. This is likely to extend due to their
adaptability to evolving conditions and a tilt in the revenue mix towards non‐linear pricing models and service lines such
as consulting, products and platforms. Our conversations with various industry bodies and CIOs also suggest that
volume growth is likely to be robust. We believe the c11% outperformance of the CNXIT Index in recent months owes
less to the weakening of the INR and more to the opportunity for an expansion in market share that is being created by
global events. The outlook for 2012 is improved by the likely extension of investments by US companies, opening up of
Western European market to offshoring and further expansion in market share at the expense of global firms. These
drivers may sustain the outperformance of the CNXIT Index in 2012. We initiate coverage on HCLT (Buy) and resume
coverage on TCS (Add). Risks to our call are exchange rate volatility and further weakening of the global economy.
2011‐2012 differs from 2008‐2009 – opportunities outweigh threats
A trend analysis of the S&P500 performance in the aftermath of two events – a) insolvency of mega
financial entities in 2008; and b) the US credit rating downgrade in Aug11 – reveal that the two
scenarios are different in several ways. Within three months of the insolvency of Lehman Brothers in
Sep08, a key trigger of the global meltdown, consensus earnings estimates of the S&P500 Index for
2009 fell by 23.5%, whereas in the three‐month period following the US credit rating downgrade in
Aug11, estimate revisions for 2012 have been within low single digits. Similar is the case with
consensus earnings revisions of the FTSE and Stoxx indices. Notably, revisions have been far lower in
key sectors in the US such as Financials, Manufacturing, and Energy & Utilities that drive revenues of
the Indian IT industry. The outlook for 2012 is improved by the likely extension of investments by US
companies, opening up of the Western European market to offshoring and further expansion in market
share at the expense of global firms.
Outperformance largely driven by fundamentals and not the INR
Substantiating our argument, the CNXIT Index has outperformed the Nifty between Aug11 and Dec11
by c11%. While the depreciation of the INR is largely believed to be the reason for the outperformance,
we think this only provides a partial explanation. Our belief stems from the fact that the INR
depreciated against the USD by 4.3% within three months of the collapse of a mega financial entity in
Sep08 and yet the CNXIT Index underperformed the Nifty. There has also been very little revision of
EPS forecasts in the past five months, despite INR depreciation. We, therefore, believe the
opportunities presented by the relatively stable business environment justify the outperformance and
current valuations.
Market share expansion of Indian companies likely to persist
Indian IT companies have been gaining market share against global peers such as International
Business Machines (IBM US, NR) and Accenture (ACN US NR) as well as against service providers
located in low‐cost destinations such as China and Philippines. Tier‐I companies had expanded their
market share at the expense of smaller companies during 2009‐2010, primarily due to their larger size
and scale, along with their diverse offerings that enable them to withstand pricing declines better and
the benefit from vendor consolidation. The secular trend in IT offshoring is likely to continue, driven by
areas such as System Integration (SI) and IT Consulting, and Indian IT vendors are likely to gain further.
Global hardware and product sales in the Sep11 quarter indicate strong growth for IT services
providers in the near term; however, the medium‐term risks remain.
Non‐linear revenue contribution to growth likely to extend
Indian IT companies are moving away from being ‘low‐cost offshoring’ vendors to strategic roles such
as consulting, which involve greater client engagement, while also focusing on non‐linear sources of
revenues such as products and platforms around new technologies such as cloud computing. The share
of fixed‐price contracts has gone up from 25%‐30% three years ago to 45%‐50% currently, while the
revenue per employee has also increased steadily, substantiating this trend. Limited pricing power,
rising employee expenses and lower operating levers are some of the drivers of the strategic shift in
focus of IT firms.
Premium valuations to Nifty likely to sustain; prefer large caps
Following the recent outperformance, the IT sector is currently trading at a P/E premium to the Nifty.
The premium has risen significantly in the past year. However, the discount in the P/E of large stocks to
their two‐year mean P/E appears unjustified, given the strong earnings forecasts for the sector. Even
after accounting for growth, on PEG basis the sector valuation is at a discount to the two‐year mean.
Within the sector, not surprisingly, large cap IT companies witnessed double‐digit outperformance over
their mid‐cap peers in the last quarter of 2011, due to their sustained superiority in earnings and
expansion in market share. Given the superior earnings forecasts for the IT sector vis‐à‐vis the Nifty,
the P/E premium is likely to continue and Tier‐I companies are likely to continue to outperform midcaps,
both in terms of earnings growth as well as P/E valuation, given secular trends such as vendor
consolidation, and transformational work favoring larger companies. Risks to our call are exchange rate
volatility and further weakening of the global economy.
Resume coverage on TCS and initiate coverage on HCLT
HCL Technologies (HCLT): The large multi‐year deals worth USD6.5bn signed between FY08 and FY11,
high exposure to IMS, and the leadership position in Product Engineering and EAS may drive earnings
growth in the high‐teens till FY14. A high amount of deal churn is likely to benefit HCLT, given its
aggressive pricing strategy. We forecast IT services revenues to grow at a CAGR of 19% over FY12‐FY14
in INR terms, driven by a CAGR of 22% in IMS. We estimate a 45‐bp decline in EBITDA margins, and
forecast EPS to grow at a CAGR of 18% over FY12‐FY14. We assume a target P/E of 13.0x Dec12 EPS,
and arrive at a Dec12 TP of INR500, implying an upside of 29%. Initiate coverage with a Buy rating.
Tata Consultancy Services (TCS): The strength in BFSI and the higher exposure to emerging markets are
likely to help TCS deliver a CAGR of 18% in volumes over FY12f‐FY14f. However, we estimate EBITDA
margins to decline by 154‐bp, given peak utilization levels, INR appreciation and low SG&A expenses,
while leaving few levers for margin improvement. Forex losses are likely to impact the bottom line
negatively in FY12f and FY13f. We estimate earnings to grow at a CAGR of 17% over FY12f‐FY14f. We
arrive at a Dec12 target of INR1,304, based on a one‐year forward P/E of 19x. This implies an upside of
12%. We resume coverage with an Add rating.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
The relative stability of consensus forecasts of S&P500 earnings in 2011
suggests that the risks are lower compared to 2008. Key sectors in the
US, such as Financials, have shown greater resilience, while the changing
attitude towards outsourcing by European companies may provide an
opportunity. Indian firms are likely to continue adding to their global
market share, as they benefit from secular trends such as a rise in
offshoring in SI and Consulting. Contrary to general perception, the
outperformance of the CNXIT Index in late 2011 may not be largely
driven by the INR decline, but is attributable more to the relative
stability of global demand. The potentially stronger earnings growth is
likely to support the premium valuation of the CNXIT Index relative to
the Nifty with secular trends favoring Tier‐I firms. Resume coverage on
TCS (Add); initiate coverage on HCLT (Buy).
Opportunities from the global crisis may outweigh the risks this time
The relative stability of consensus forecasts in 2011 suggests that the risks are
lower compared to 2008. Earnings forecasts of the S&P500 have declined by just
4.0% in 2011, well below the 23.5% erosion in 2008. Key sectors such as
Financials and Manufacturing, that drive revenues of the Indian IT industry, have
shown greater resilience. Consensus forecasts of earnings of the FTSE and Stoxx
also suggest a better outlook for Europe than in 2008. The changing attitude
towards outsourcing by European firms may provide an opportunity for Indian IT.
Share of global pie likely to expand even further
The 2008‐2009 recession had seen Indian IT firms add an estimated 2% to their
global market share against global peers. The market share is likely to expand
even further as Indian firms continue to benefit from secular trends such as
vendor consolidation and deal churn, owing to their large scale and diverse
offerings. Indian vendors are well‐poised to gain from a rise in offshoring in
System Integration (SI) and Consulting. A tilt in revenue mix towards non‐linear
pricing models would also help sustain pricing and overcome cost pressures.
INR weakness only partly drives rally, business outlook a stronger force
The outperformance in late 2011 may not have been largely driven by the INR
decline—as seen from the stability of FY12 EPS forecasts. Moreover, the
comparable situation in 2008 indicates that a weak INR cannot offset the
weakness in ultimate demand. Performance of the CNXIT Index is attributable
more to the relative stability of global demand and greater opportunities.
Premium valuation has solid grounds; still room for upside
2011 saw the CNXIT Index regain its premium over the Nifty, yet it is at a
discount to its two‐year mean PEG. The relative stability of earnings drivers and
potentially stronger earnings growth are likely to support the premium, with
secular trends in offshoring favoring Tier‐I firms.
Resume coverage on TCS and initiate coverage on HCLT
We resume coverage on TCS (Add) with a Dec12 target of INR1,304, and initiate
coverage on HCLT (Buy) with a Dec12 target of INR500. Key risks are INR
volatility and a worsening global economy.
The current global business environment poses far lower risk to the Indian IT industry compared with that triggered by
the insolvency of several mega financial entities in 2008. Earnings forecasts of S&P500 companies in the US, the major
market for Indian IT, have declined by barely 4.0%, well below the 23.5% erosion in forecasts in 2008. Key US sectors
such as Financials, Manufacturing, Energy and Utilities are in much better shape today than in 2008. The 2008‐2009
recession had seen Indian firms add an estimated 2% to their global market share. This is likely to extend due to their
adaptability to evolving conditions and a tilt in the revenue mix towards non‐linear pricing models and service lines such
as consulting, products and platforms. Our conversations with various industry bodies and CIOs also suggest that
volume growth is likely to be robust. We believe the c11% outperformance of the CNXIT Index in recent months owes
less to the weakening of the INR and more to the opportunity for an expansion in market share that is being created by
global events. The outlook for 2012 is improved by the likely extension of investments by US companies, opening up of
Western European market to offshoring and further expansion in market share at the expense of global firms. These
drivers may sustain the outperformance of the CNXIT Index in 2012. We initiate coverage on HCLT (Buy) and resume
coverage on TCS (Add). Risks to our call are exchange rate volatility and further weakening of the global economy.
2011‐2012 differs from 2008‐2009 – opportunities outweigh threats
A trend analysis of the S&P500 performance in the aftermath of two events – a) insolvency of mega
financial entities in 2008; and b) the US credit rating downgrade in Aug11 – reveal that the two
scenarios are different in several ways. Within three months of the insolvency of Lehman Brothers in
Sep08, a key trigger of the global meltdown, consensus earnings estimates of the S&P500 Index for
2009 fell by 23.5%, whereas in the three‐month period following the US credit rating downgrade in
Aug11, estimate revisions for 2012 have been within low single digits. Similar is the case with
consensus earnings revisions of the FTSE and Stoxx indices. Notably, revisions have been far lower in
key sectors in the US such as Financials, Manufacturing, and Energy & Utilities that drive revenues of
the Indian IT industry. The outlook for 2012 is improved by the likely extension of investments by US
companies, opening up of the Western European market to offshoring and further expansion in market
share at the expense of global firms.
Outperformance largely driven by fundamentals and not the INR
Substantiating our argument, the CNXIT Index has outperformed the Nifty between Aug11 and Dec11
by c11%. While the depreciation of the INR is largely believed to be the reason for the outperformance,
we think this only provides a partial explanation. Our belief stems from the fact that the INR
depreciated against the USD by 4.3% within three months of the collapse of a mega financial entity in
Sep08 and yet the CNXIT Index underperformed the Nifty. There has also been very little revision of
EPS forecasts in the past five months, despite INR depreciation. We, therefore, believe the
opportunities presented by the relatively stable business environment justify the outperformance and
current valuations.
Market share expansion of Indian companies likely to persist
Indian IT companies have been gaining market share against global peers such as International
Business Machines (IBM US, NR) and Accenture (ACN US NR) as well as against service providers
located in low‐cost destinations such as China and Philippines. Tier‐I companies had expanded their
market share at the expense of smaller companies during 2009‐2010, primarily due to their larger size
and scale, along with their diverse offerings that enable them to withstand pricing declines better and
the benefit from vendor consolidation. The secular trend in IT offshoring is likely to continue, driven by
areas such as System Integration (SI) and IT Consulting, and Indian IT vendors are likely to gain further.
Global hardware and product sales in the Sep11 quarter indicate strong growth for IT services
providers in the near term; however, the medium‐term risks remain.
Non‐linear revenue contribution to growth likely to extend
Indian IT companies are moving away from being ‘low‐cost offshoring’ vendors to strategic roles such
as consulting, which involve greater client engagement, while also focusing on non‐linear sources of
revenues such as products and platforms around new technologies such as cloud computing. The share
of fixed‐price contracts has gone up from 25%‐30% three years ago to 45%‐50% currently, while the
revenue per employee has also increased steadily, substantiating this trend. Limited pricing power,
rising employee expenses and lower operating levers are some of the drivers of the strategic shift in
focus of IT firms.
Premium valuations to Nifty likely to sustain; prefer large caps
Following the recent outperformance, the IT sector is currently trading at a P/E premium to the Nifty.
The premium has risen significantly in the past year. However, the discount in the P/E of large stocks to
their two‐year mean P/E appears unjustified, given the strong earnings forecasts for the sector. Even
after accounting for growth, on PEG basis the sector valuation is at a discount to the two‐year mean.
Within the sector, not surprisingly, large cap IT companies witnessed double‐digit outperformance over
their mid‐cap peers in the last quarter of 2011, due to their sustained superiority in earnings and
expansion in market share. Given the superior earnings forecasts for the IT sector vis‐à‐vis the Nifty,
the P/E premium is likely to continue and Tier‐I companies are likely to continue to outperform midcaps,
both in terms of earnings growth as well as P/E valuation, given secular trends such as vendor
consolidation, and transformational work favoring larger companies. Risks to our call are exchange rate
volatility and further weakening of the global economy.
Resume coverage on TCS and initiate coverage on HCLT
HCL Technologies (HCLT): The large multi‐year deals worth USD6.5bn signed between FY08 and FY11,
high exposure to IMS, and the leadership position in Product Engineering and EAS may drive earnings
growth in the high‐teens till FY14. A high amount of deal churn is likely to benefit HCLT, given its
aggressive pricing strategy. We forecast IT services revenues to grow at a CAGR of 19% over FY12‐FY14
in INR terms, driven by a CAGR of 22% in IMS. We estimate a 45‐bp decline in EBITDA margins, and
forecast EPS to grow at a CAGR of 18% over FY12‐FY14. We assume a target P/E of 13.0x Dec12 EPS,
and arrive at a Dec12 TP of INR500, implying an upside of 29%. Initiate coverage with a Buy rating.
Tata Consultancy Services (TCS): The strength in BFSI and the higher exposure to emerging markets are
likely to help TCS deliver a CAGR of 18% in volumes over FY12f‐FY14f. However, we estimate EBITDA
margins to decline by 154‐bp, given peak utilization levels, INR appreciation and low SG&A expenses,
while leaving few levers for margin improvement. Forex losses are likely to impact the bottom line
negatively in FY12f and FY13f. We estimate earnings to grow at a CAGR of 17% over FY12f‐FY14f. We
arrive at a Dec12 target of INR1,304, based on a one‐year forward P/E of 19x. This implies an upside of
12%. We resume coverage with an Add rating.
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