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India IT Services
Mid-cap mantra for growth
Initiate coverage on mid-caps; 3 OP ideas – HEXW top pick
ƒ Time to play catch up. Stock returns from the mid-cap IT group have lagged
those of large-cap stocks YTD, but we see an opportunity for a catch-up in
performance in 2011 due to strong fundamentals (25-30% top-line growth)
and positioning in selected niche value-added segments. We thus initiate on
Hexaware (leverage to PeopleSoft implementation), Mindtree (Product
Engineering and Testing) and Persistent (OPD) with OP ratings and TPs
representing 27-33% upside potential to share prices.
ƒ Comments from tech giants encouraging. A series of disappointing US
macro data has dampened investor sentiment on demand. Even so, strength
in outsourcing order backlogs at Accenture (23% increase QoQ) plus the
strength in new software license sales (up 25% YoY) for both Oracle and SAP
point to a healthy pipeline for the outsourcing market. More important, unlike
the GFC, the deal flow has not come to a standstill, and smaller ticket size
deals should be enough to provide revenue momentum for mid-cap players.
Top-line growth leads to margin expansion and a PER rerate
ƒ We see margin expansion in FY11. With a return of growth and more
normal wage hikes, we expect margins this year to expand by 100-400bp.
This would represent a significant reversal from FY10, when the mid-cap IT
names suffered a double challenge: growth stagnated and investment in sales
and wage hikes contributed to margin pressures.
Trickle down effect to augment deal pipeline for Tier2
ƒ Secular growth story…The FY11 performance of large-cap players and the
latest sound bytes from the global tech majors have inspired confidence in the
secular theme of the Indian IT outsourcing industry.
ƒ …not translating into broad-based stock outperformance. Despite the
return to broad-based growth, mid-cap stock returns have been patchy over the
last 30 months. This was due to a less sanguine demand outlook and investor
scepticism about margins. We expect these concerns to be alleviated in FY12.
ƒ Look for 3Ps - Niche position/profitability/PER. Our stock selection is
based on picking winners by screening them on three Ps that we believe are
crucial for stock outperformance. Our detailed schematic in Fig 5 screens
seven mid-cap names and attempts to answer three questions:
⇒ What is so special about this company? – Niche Position
⇒ Margin profile and earnings growth? – Profitability
⇒ Where is the valuation? PER and where it stands vs. history
⇒ Hexaware, Persistent, Mindtree and KPIT screen well on our analysis.
Key risks: Margin headwinds
ƒ Margin key to our thesis. Our investment view of our OP-rated mid-cap
stocks emanates from the belief that revenue growth in FY12 could trigger
margin expansion vs. the FY11 level. These stocks faced wage inflation and
INR appreciation last year, and with robust demand, we think they should be
able to reverse the profitability trend seen last year.
Mid-cap mantra for growth
ƒ Information Technology is the way for FY12. We are presenting the Macquarie IT
coverage universe spread across large-cap and mid/small-cap companies. We expect this
sector to show 28%+ US$ revenue growth for FY12, with 25-35% US$ revenue growth for
the mid-caps.
Fig 1 Macquarie IT Universe – Snapshot
Name Ticker Reco
Market
Cap
(In US$ m)
Share
price
(Rs)
TP
(Rs)
FY12E
PER
(x)
TP
FY12E
PER
(x) Comments
Large Cap
TCS TCSIN OP 46,508 1069
1,360
20.3 26x
ƒ Industry leading volume growth and excellent margin execution in the last 18
months
ƒ High expectations and superb stock outperformance leaves little room for
error
ƒ On track to achieve 10% incremental revenues from non-linear initiatives by
March, 12
Infosys INFOIN OP 34,571 2710
3,650
18.9 26x
ƒ Stock has been overpenalised for weak FY12 guidance
ƒ Retain our OP call and see better returns vs. TCS over next 12 months
ƒ Management changes unlikely to dilute profitability focus
Wipro WPROI
N
OP 21,951 402 540 17.2 23x
ƒ Hurt by skewed revenue mix and slower response to revival
ƒ Top deck reshuffle could translate into financial performance with a lag –
testing investor patience
ƒ Attrition at higher levels could pose headline risk for the company
HCLT HCLTI
N
OP 7,111 465 615 13.7 18x ƒ Our preferred pick to play return in discretionary spending
ƒ Strength in infra management and EAS expertise – twin levers of growth
ƒ We are 6% and 8% ahead of Street on FY12/13 EPS, respectively
Mid/Small Cap
Mphasis MPHL
IN
UP 1,984 425 380 11.0 10x
ƒ Thesis on structural margin weakness playing out
ƒ The pain due to sluggish HP channel may continue for another two quarters
ƒ Consensus still too aggressive; wait for estimates to reset
Rolta RLTA
IN
OP 440 123 195 5.9 9x ƒ Niche India IT play with domestic revenues contributing ~60% of revenues
ƒ Indian Defense forces largest client for Rolta
New initiations – Analysing these names on 3Ps (Positioning, Profitability and PER)
Persistent PSYS
IN
OP 301 339 450 10.0 13x
ƒ Niche player in Outsourced Product Development (OPD)
ƒ Stable EBITDA margin profile of early-to-mid 20s.
ƒ FY12 earnings base depressed as tax benefits are set to lapse; forecast 19%
earnings growth in FY13
Hexaware HEXW
IN
OP 432 66 85 10.4 14x
ƒ Strength in PeopleSoft and travel and tourism domain
ƒ EBIT margins to expand from 7% lows in FY08 to 12% in FY12E
ƒ FY12E EPS 3% above Street estimate, stock available at 11x FY12E
Mindtree MTCL
IN
OP 318 355 450 9.5 12x ƒ Solid credentials in Product Engineering services (PES), with specialization
in Bluetooth technologies
ƒ Foray in handset manufacturing behind us, estimate FY13 margins to
improve by 290bps vs FY11
ƒ At 9x FY12E, most attractively valued among peers
Note: Stock prices as of 20 June 2011.
Source: Bloomberg, Macquarie Research, June 2011
3 new Outperform ideas: HEXW, MTCL and PSYS
ƒ We initiate coverage on the Indian mid-cap space with OP recommendations on
Hexaware, Mindtree and Persistent Systems. Our positive investment view is based on:
⇒ The strength of niche service offerings of each of these players.
⇒ The return of secular demand growth, as evidenced by guidance and the comments of
Global Tech players.
⇒ Margin improvement following a return to a normal wage hike cycle and a stable
currency.
⇒ Improved profitability is helping these players to narrow the stock performance gap vs.
Tier 1 players.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India IT Services
Mid-cap mantra for growth
Initiate coverage on mid-caps; 3 OP ideas – HEXW top pick
ƒ Time to play catch up. Stock returns from the mid-cap IT group have lagged
those of large-cap stocks YTD, but we see an opportunity for a catch-up in
performance in 2011 due to strong fundamentals (25-30% top-line growth)
and positioning in selected niche value-added segments. We thus initiate on
Hexaware (leverage to PeopleSoft implementation), Mindtree (Product
Engineering and Testing) and Persistent (OPD) with OP ratings and TPs
representing 27-33% upside potential to share prices.
ƒ Comments from tech giants encouraging. A series of disappointing US
macro data has dampened investor sentiment on demand. Even so, strength
in outsourcing order backlogs at Accenture (23% increase QoQ) plus the
strength in new software license sales (up 25% YoY) for both Oracle and SAP
point to a healthy pipeline for the outsourcing market. More important, unlike
the GFC, the deal flow has not come to a standstill, and smaller ticket size
deals should be enough to provide revenue momentum for mid-cap players.
Top-line growth leads to margin expansion and a PER rerate
ƒ We see margin expansion in FY11. With a return of growth and more
normal wage hikes, we expect margins this year to expand by 100-400bp.
This would represent a significant reversal from FY10, when the mid-cap IT
names suffered a double challenge: growth stagnated and investment in sales
and wage hikes contributed to margin pressures.
Trickle down effect to augment deal pipeline for Tier2
ƒ Secular growth story…The FY11 performance of large-cap players and the
latest sound bytes from the global tech majors have inspired confidence in the
secular theme of the Indian IT outsourcing industry.
ƒ …not translating into broad-based stock outperformance. Despite the
return to broad-based growth, mid-cap stock returns have been patchy over the
last 30 months. This was due to a less sanguine demand outlook and investor
scepticism about margins. We expect these concerns to be alleviated in FY12.
ƒ Look for 3Ps - Niche position/profitability/PER. Our stock selection is
based on picking winners by screening them on three Ps that we believe are
crucial for stock outperformance. Our detailed schematic in Fig 5 screens
seven mid-cap names and attempts to answer three questions:
⇒ What is so special about this company? – Niche Position
⇒ Margin profile and earnings growth? – Profitability
⇒ Where is the valuation? PER and where it stands vs. history
⇒ Hexaware, Persistent, Mindtree and KPIT screen well on our analysis.
Key risks: Margin headwinds
ƒ Margin key to our thesis. Our investment view of our OP-rated mid-cap
stocks emanates from the belief that revenue growth in FY12 could trigger
margin expansion vs. the FY11 level. These stocks faced wage inflation and
INR appreciation last year, and with robust demand, we think they should be
able to reverse the profitability trend seen last year.
Mid-cap mantra for growth
ƒ Information Technology is the way for FY12. We are presenting the Macquarie IT
coverage universe spread across large-cap and mid/small-cap companies. We expect this
sector to show 28%+ US$ revenue growth for FY12, with 25-35% US$ revenue growth for
the mid-caps.
Fig 1 Macquarie IT Universe – Snapshot
Name Ticker Reco
Market
Cap
(In US$ m)
Share
price
(Rs)
TP
(Rs)
FY12E
PER
(x)
TP
FY12E
PER
(x) Comments
Large Cap
TCS TCSIN OP 46,508 1069
1,360
20.3 26x
ƒ Industry leading volume growth and excellent margin execution in the last 18
months
ƒ High expectations and superb stock outperformance leaves little room for
error
ƒ On track to achieve 10% incremental revenues from non-linear initiatives by
March, 12
Infosys INFOIN OP 34,571 2710
3,650
18.9 26x
ƒ Stock has been overpenalised for weak FY12 guidance
ƒ Retain our OP call and see better returns vs. TCS over next 12 months
ƒ Management changes unlikely to dilute profitability focus
Wipro WPROI
N
OP 21,951 402 540 17.2 23x
ƒ Hurt by skewed revenue mix and slower response to revival
ƒ Top deck reshuffle could translate into financial performance with a lag –
testing investor patience
ƒ Attrition at higher levels could pose headline risk for the company
HCLT HCLTI
N
OP 7,111 465 615 13.7 18x ƒ Our preferred pick to play return in discretionary spending
ƒ Strength in infra management and EAS expertise – twin levers of growth
ƒ We are 6% and 8% ahead of Street on FY12/13 EPS, respectively
Mid/Small Cap
Mphasis MPHL
IN
UP 1,984 425 380 11.0 10x
ƒ Thesis on structural margin weakness playing out
ƒ The pain due to sluggish HP channel may continue for another two quarters
ƒ Consensus still too aggressive; wait for estimates to reset
Rolta RLTA
IN
OP 440 123 195 5.9 9x ƒ Niche India IT play with domestic revenues contributing ~60% of revenues
ƒ Indian Defense forces largest client for Rolta
New initiations – Analysing these names on 3Ps (Positioning, Profitability and PER)
Persistent PSYS
IN
OP 301 339 450 10.0 13x
ƒ Niche player in Outsourced Product Development (OPD)
ƒ Stable EBITDA margin profile of early-to-mid 20s.
ƒ FY12 earnings base depressed as tax benefits are set to lapse; forecast 19%
earnings growth in FY13
Hexaware HEXW
IN
OP 432 66 85 10.4 14x
ƒ Strength in PeopleSoft and travel and tourism domain
ƒ EBIT margins to expand from 7% lows in FY08 to 12% in FY12E
ƒ FY12E EPS 3% above Street estimate, stock available at 11x FY12E
Mindtree MTCL
IN
OP 318 355 450 9.5 12x ƒ Solid credentials in Product Engineering services (PES), with specialization
in Bluetooth technologies
ƒ Foray in handset manufacturing behind us, estimate FY13 margins to
improve by 290bps vs FY11
ƒ At 9x FY12E, most attractively valued among peers
Note: Stock prices as of 20 June 2011.
Source: Bloomberg, Macquarie Research, June 2011
3 new Outperform ideas: HEXW, MTCL and PSYS
ƒ We initiate coverage on the Indian mid-cap space with OP recommendations on
Hexaware, Mindtree and Persistent Systems. Our positive investment view is based on:
⇒ The strength of niche service offerings of each of these players.
⇒ The return of secular demand growth, as evidenced by guidance and the comments of
Global Tech players.
⇒ Margin improvement following a return to a normal wage hike cycle and a stable
currency.
⇒ Improved profitability is helping these players to narrow the stock performance gap vs.
Tier 1 players.
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