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India Computer Services
Steady demand flow, but little room to disappoint
„Steady demand, 2011 budgets likely flat to up
Conversations with Infosys, TCS and Wipro and channel checks indicate demand
momentum remains steady, with continued uptick in discretionary spending.
German market showing good traction. Financial services continue to be a major
driver as banks look at technology as a competitive tool and also for compliance.
Cost compulsions driving manufacturing/retail. 2011 IT budgets likely flat to up.
“Global” sourcing vs. India sourcing
One interesting trend that came up in a few of our client/consultant conversations
is that customers are looking at “global sourcing” as opposed to India-centric
sourcing, given concentration risks and perhaps need to be closer to the client.
Some price hikes, but not a trend; Attrition under control
Pricing continues to be broadly stable. While some increases are coming through,
we think it is early yet to call it a trend, and not easy to negotiate. Employee
attrition trends remain flat to down, as seen in September, as salary
hikes/promotions take effect.
Currency volatility a challenge
Indian IT index has outperformed the Sensex by 7% in the last 1-month, with
Rupee nearly touching RS46/USD in Nov. depreciating 4% from a high of Rs44.1
in mid Oct., but is back to Rs44.6, as we write. This volatility remains one of the
greatest challenges for IT services exporters, from a cost and margin
management perspective. As things stand today, the avg. Re/USD for the Dec.
quarter is likely to be about 4% stronger, impacting margins by 120-160bps qoq.
Rs/Euro and Rs/AUD movement favorable and could offset hit marginally. We
expect Rupee strength to continue until March and then could see weakening.
Macro risks continue; Prefer Wipro/HCLT on risk reward
However, macro risks continue to cloud visibility and lack of business confidence
could temper pace of spending, which could cap stock price upside in our view
given fair valuations of 21-22x FY12PE for Infy and TCS with FY11-13e EBITDA
growth of 17-19% CAGR. Prefer TCS on scope to surprise on tight management.
Wipro (17xFY12PEe) & HCLT (14xFY12PE) attractive on valuation ; with FY11-
13 EBITDA growth of 22% (on lower base) \; 26% (as margins bottom) resp.
Hexaware / Educomp remain our mid-cap picks.
Price objective basis & risk
Educomp Solu (EUSOF)
Our PO of Rs810 is based on a 2-year PEG of 0.9x and implies a target multiple
of 18x FY12e. Our PO reflects potential de-rating given that the Smart Class
revenue stream is now likely to be volatile. We retain our Buy given the strong
24% CAGR in earnings FY11-13E, and the turnaround in FCF on shift to new
business model. Besides Educomp remains the only listed education service
provider with offerings in K-12 and is a emerging player in vocational/
supplemental education.
Risks to our valuation are higher losses in new initiatives, higher-than-anticipated
cut in Smart Class pricing, acquisition-related risks and managing multiple
growth initiatives.
HCL (XHCLF)
Our Price Objective of Rs500 assumes re rating from the current FY12e PE of
14x to 17x.. We believe this is justified as it implies what we believe to be a
conservative EV/E to Ebitda g of 0.65, a discount of 20% to Wipro' s target EEG.
Downside risks stem from higher than expected investments, slowdown in pick up
of discretionary IT spend due to macro recovery faltering, higher than expected
wage hike pressures and Rupee appreciation.
Hexaware Tech (XFTCF)
Our PO of Rs110 is at 10x CY11E at 25% discount to mid-tier peers given high
revenue concentration and exposure to discretionary spends like ERP. We expect the
stock to re-rate on back of improving revenue visibility and turnaround in margins.
Downside risks: Slower-than-expected margin expansion, risk to PeopleSoft
implementation revenues, and industrywide risks of growing competition, wage
pressures and Rupee appreciation. Upside risks: Large deal closures currently
being pursued by the company.
Infosys Tech (INFYF / INFY)
Our Price Objective of Rs3,300 (US$73 for ADR, at parity) is based on a target
EV/EBITDA to 2yr EBITDA growth of 1.0x, about 10pc higher than its 5yr avg
given its improved global standing led by scale, a more diversified rev mix and its
move up the value chain. This implies a 1-year forward (FY12e P/E) multiple of
23x. Downside risks to estimates stem from cutback of IT budgets, led by the
macro recovery faltering or sharp appreciation of the Rupee.
Tata Consultancy (TACSF)
Our PO of Rs 1,120 is based on an EV/E to Ebitda g of 1x in line with Infosys.
This implies a target FY12e PE of 23x. Downside risks stem from cutback of IT
budgets led by macro recovery faltering or sharp appreciation of the Rupee.
Wipro (WIPRF / WIT)
Our Price Objective of Rs520 is set at almost 15% discount to Infy. While the
company has a promising growth strategy, we would wait to see signs of
execution before narrowing the discount. This implies a FY12e PE target of 20x,
in line with its 2-3 yr earnings growth forecast. Downside risks to estimates stem
from cutback of IT budgets led by macro recovery faltering, further rise in
employee attrition or sharp appreciation of the Rupee.
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