Traditional outsourcing deals are unlikely
to drive the next industry up-cycle
Newer growth areas are coming up, but
deals are small and cyclical in nature
Despite higher valuations, we continue
to prefer TCS. We shave our PE-based
target price for Infosys modestly
��
As sector growth slows in the next cycle (we forecast a
CAGR of c15% over FY12-15e vs 40% in FY06-08 and
22% in FY10-12), we expect the contours of growth to shift
as well, altering the rules of the game. We foresee a broad
structural move from long-term annuity-based outsourcing
and offshoring deals to smaller, technology-oriented deals
and a higher dependence on discretionary and fresh IT
spending. We expect growth therefore to become more
cyclical and – importantly – less uniform across companies.
The next big thing. Our forecasts suggest that even modest
growth of 15% in FY14 would require new business (in dollar
terms) nearly equal to the pre-subprime era, which may not
be trivial to achieve. We believe more than three-quarters of
the traditional business drivers, such as banking and enterprise
application services (EAS), that have led the last two upcycles
have seen a structural change and are missing the
triggers this time to significantly accelerate growth in FY14.
Not the end of the road, but a tougher journey ahead. While
traditional markets may not lead the cycle this time, there are
multiple growth accelerators we believe may provide upside
to growth estimates, such as mobility, analytics, or database
technology, but most of these growth areas are technologyoriented
– not specific to any market – resulting in much
smaller-size deals (unlike a typical outsourcing deal). This
means the resulting growth will likely be cyclical and difficult
to forecast. This report addresses in detail the trends in key
demand markets such as banking and EAS.
Market share game limited to few, such as TCS. A cyclical
demand recovery could lift all boats, providing upside to the
current FY14 consensus. However, as macro uncertainty
remains high, we think companies that offer broader service
portfolios in mature markets, like BFSI, and are investing in
building capabilities in the newer technology areas will
continue to lead the industry. We continue to prefer TCS
among the top three companies in terms of revenue and market
cap. Weaker INR is the key upside risk to our estimates.
Tata Consultancy Services
TCS IN – INR1,226; Overweight; TP INR1,365
The stock is trading at 19x our FY13e EPS. TCS,
in our view, is the best-placed Indian company to
continue to gain market share in the banking
market. We believe that TCS has a diversified
service mix and a go-to-market strategy that
encourages banks to consolidate their vendor
landscape and therefore plays out in favour of
TCS’s strengths. If IT spend by banks were to
continue to improve in the coming quarters, that
would add incremental growth to TCS, possibly
above our current forecasts.
We value the stock at 20x our FY14e EPS, for a
12-month target price of INR1,365.
Under our research model, the Neutral rating band
for non-volatile Indian equities equals the local
hurdle rate of 11% plus or minus 5%. At the time
we set our target price, it implied a potential
return above this band; we therefore rate the
shares Overweight. Potential return equals the
percentage difference between the current share
price and the target price, including the forecast
dividend yield when indicated.
Downside risks to our view: A macroeconomic
slowdown represents the primary downside risk.
Weakness in the BFSI sector also could materially
impact TCS’s revenue. INR appreciation could
affect margins negatively.
HCL Technologies
HCLT IN – INR488; Overweight, TP 570
The stock is trading at 13x our FY13e EPS.
HCLT is benefiting from its strategy of targeting
the restructured deal business and thereby market
share-led growth. These are mostly integrated
deals and lower in profitability than the usual
T&M ADM business, in our view, but much more
strategic in nature. We believe, as suggested by
the outsourcing advisers TPI as well, that the
number of restructured deals will increase 20% in
2012. This would mean further opportunities for
HCLT to gain market share and continue its
above-sector growth trajectory. We still do not
believe the company can see margin expansion as
large deals ramp up. We estimate margins will fall
by 100bp y-o-y in FY13 and expect HCLT to
have top-line-led earnings growth. Among
positive factors, consensus margin expectations
have decreased in the past few months and now
are in line with our forecasts, lowering the risk of
disappointment.
We value HCLT at 14x earnings for end-March
2014e (in line with other companies in our
coverage), and our 12-month target price is INR570.
Under our research model, the Neutral rating band
for non-volatile Indian equities equals the local
hurdle rate of 11% plus or minus 5%. At the time
we set our target price, implied a potential return
above this band; we therefore have an Overweight
rating on HCLT shares. Potential return equals the
percentage difference between the current share
price and the target price, including the forecast
dividend yield when indicated.
Downside risks to our view: Macro uncertainty
remains the primary downside risk to our rating
and estimates. Also, INR appreciation versus the
USD (every 1% appreciation affects margins by
30-40bp) remains a concern.
Wipro
WPRO IN – INR404, Neutral, TP INR 430
Wipro is currently trading at a multiple of 16x our
FY13 earnings estimate. We value Wipro on 15x
FY14e (in line with Infosys). We maintain our
Neutral rating and INR430 (rounded) target price.
Under our research model, the Neutral rating band
for non-volatile Indian equities equals the local
hurdle rate of 11% plus or minus 5%. At the time
we set our target price, it implied a potential
return within this band; we therefore rate the
shares Neutral. Potential return equals the
percentage difference between the current share
price and the target price, including the forecast
dividend yield when indicated.
Risks to our rating and estimates: On the
downside, macroeconomic deterioration remains
the primary risk to achieving consistent volume
growth and pricing stability. The poor cash
conversion of previous quarters remains a concern
as well. On the upside, faster-than-expected
conversion of deals and client mining remain the
primary risks.
Infosys Limited
INFO IN – INR 2,339; Neutral, TP INR2,590
Infosys is seeing a significant slowdown in
growth and we believe a valuation de-rating is
justified. However, we note that the company has
a strong balance sheet, with >50% ROCE, >30%
ROE and USD4bn in cash. The stock is trading at
15x our FY13e EPS and 13x our revised FY14e
EPS. We cut our earnings estimates for FY14 by
2.3% to account for its high exposure to EAS. We
value the stock at 15x FY14e EPS (from 18x
FY13e EPS historical average), as we expect
earnings growth to significantly slow) and lower
our target price to INR 2,590 from INR 2,655.
Under our research model, the Neutral rating band
for non-volatile Indian equities equals the local
hurdle rate of 11% plus or minus 5%, which
translates into a potential return range of 6-16%.
Our new target price implies a potential return
(including forecast dividend yield) of c13%,
which is within this band; we therefore continue
to rate the shares Neutral. Potential return equals
the percentage difference between the current
share price and the target price, including the
forecast dividend yield when indicated.
Risks to our view: On the downside, deteriorating
macroeconomic conditions is the primary risk, as
this could result in delays in decision-making and,
therefore, project ramp-ups. Although management
is confident of maintaining an EBIT margin of
around 27% even if the rupee appreciates to 46,
we believe any INR appreciation would impact
sentiment and the stock’s valuation. On the
upside, a more aggressive go-to-market strategy
and faster-than-expected conversion of deals is
the primary risk.
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