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IT Services
Equity Research
Macro concerns may impact 2012 growth despite stable NT outlook
Deteriorating macro poses concern on FY13; lower FY13 growth
Macro conditions in the US/EU have deteriorated in the last 3 months, with
our ECS team downgrading its global 2012 GDP forecast to 4.3% (from
4.9% in Jan ’11). Within our Indian IT coverage, while mgmt comments
continue to reflect a stable near-term outlook, there is uncertainty on
demand pipeline going into 2012. We note that historically IT services
growth lags GDP by 6-8 months (67% correlation). As customers start their
budgeting process, a deteriorating outlook for 2012 could impact the dollar
value of IT budgets. We thus reduce our revenue estimates (for large-caps)
by up to 9% for FY12E-14E and forecast 14% revenue growth for FY2013E.
Margin strategies adopted will be key for FY13 earnings growth
With mid-teen FY13 revenue growth for large caps, we believe that margin
strategies adopted by mgmt will be key for FY13 growth and cash returns.
While multiple operating levers exist to enable cos. to go to preservation
mode, we believe that these may not be fully deployed. Hence, unlike FY09
where EBIT margins peaked (despite just 8% revenue growth), we expect
mgmt to strike a balance between utilizing levers and investing for future
growth. Hence, we largely retain our margin assumptions and reduce EPS
for the large caps by up to 15% for FY12E-FY14E. We roll forward our TPs
to FY13 and reduce them by 10-31% on lowered implied TP multiples.
Current prices reflect a more bearish 2012, pricing in 2008 déjà-vu
The Indian IT sector has underperformed the broader market by 10% (down
21%) in the last 3-months on above concerns. In our view, current market
prices are reflecting a 2008 déjà-vu, factoring in 10%-12% revenue growth
with headwinds to margins. In our view, this may be bearish vs. our midteen growth forecast and we believe stocks are offering better entry point.
Prefer HCL Tech and Infosys on limited downside, better valuations
We prefer HCL Tech (18%/19% revenue and EPS CAGR for FY11-FY13E)
and Infosys (limited downside on valuations) as our best Buy ideas and
reiterate Sell on Patni. We expect HCL to deliver 19% EPS CAGR over FY11-
FY13E on the back of higher deal wins. HCL is trading at 11.3x on FY13E
P/E, at a 25% discount to its historical average. On INFY, we expect 15%
EPS CAGR over FY11-FY13E, coupled with attractive valuations (14.6x on
FY13 P/E, at a 30% discount to its historical average) to re-rate the stock
Secular growth outlook remains intact despite macro concerns
We continue to believe that the secular growth story for the Indian IT outsourcing
companies is here to stay and remains intact despite multiple headwinds discussed above.
Hence, we forecast a healthy 17% and 13% revenue and EPS CAGR for the large cap
companies under our coverage for FY11-FY13E on the back of following reasons.
Management commentary remains positive for near term: Our discussions with all
the top Indian IT companies suggest that they have not seen any weakness in the
demand and no clients have gotten back to them with any concerns. All companies
unanimously confirmed a stable 2H2011, however, they did mention that 2012 looks
uncertain at this point of time. Hiring plans for all the companies are on track with no
slowing down and they will be going to the campuses for fresher offers for next year.
Offshoring is a measure to preserve margins: In times when the revenue growth for
corporates look weak, offshoring is one of the ways to preserve margins. Hence, in a
weaker outlook scenario, we may see corporate increasing their offshore mix to
preserve margins for a limited period of time.
Cost cut may not be ‘in’ IT but could be ‘through’ IT: Since 2008 crisis, major
corporates have taken a lot of cost cut initiatives to save costs in order to maintain
profitable growth. Hence, we believe that there is not much scope for the corporate to
keep cutting on costs and reduce IT budgets as it will start affecting the business
models. Hence, we do not see similar IT budget slashing for outsources as we
witnessed in 2008-09. However, we may see more vendor consolidation and vendor
churn towards companies which provide more work for the same dollar value.
Compliance work in the BFS segment may bring next leg of opportunities:
Regulatory compliance work like the Dodd Frank Act, Basel III implementation may
drive the next leg of growth for the Indian IT companies. Though the M&A integration
might be witnessing the tail end of the growth, regulatory compliance may continue
spending in the BFS corporate over the next 2-3 years considering the complexities of
the same. Companies are already trying to pre-empt the same by starting to spend on
preparing for the implementation of these regulations.
Currency is a balancer of growth: In 2008, despite single digit US$ revenue growth
(9% yoy), the reported revenue growth for Indian IT companies was 26% as INR
depreciated by more than 20%. So, the strength of USD/INR resulted in mitigating the
slowdown in revenue growth and helped cushion margin compression too. Hence, we
believe that a depreciating INR will be an upside risk in weaker global environments.
Our sensitivity (Exhibit 7) suggests that every Re1 change in INR/USD rate has about
4% sensitivity to EBIT and 3% sensitivity to EPS.
Reduced uncertainty may compel corporates to start investing again: Despite a
possibility of deferring their IT spends in case of a weaker outlook in 2012, we believe
that corporates could resume IT spending as soon as there is clarity on growth
resuming. We believe that S&P 500 companies with healthy balance sheets may look
towards investing in business and growth rather than holding it back once they have
any visibility on the economic environment. Hence, we believe we may see IT deals
picking up for Indian IT companies.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
IT Services
Equity Research
Macro concerns may impact 2012 growth despite stable NT outlook
Deteriorating macro poses concern on FY13; lower FY13 growth
Macro conditions in the US/EU have deteriorated in the last 3 months, with
our ECS team downgrading its global 2012 GDP forecast to 4.3% (from
4.9% in Jan ’11). Within our Indian IT coverage, while mgmt comments
continue to reflect a stable near-term outlook, there is uncertainty on
demand pipeline going into 2012. We note that historically IT services
growth lags GDP by 6-8 months (67% correlation). As customers start their
budgeting process, a deteriorating outlook for 2012 could impact the dollar
value of IT budgets. We thus reduce our revenue estimates (for large-caps)
by up to 9% for FY12E-14E and forecast 14% revenue growth for FY2013E.
Margin strategies adopted will be key for FY13 earnings growth
With mid-teen FY13 revenue growth for large caps, we believe that margin
strategies adopted by mgmt will be key for FY13 growth and cash returns.
While multiple operating levers exist to enable cos. to go to preservation
mode, we believe that these may not be fully deployed. Hence, unlike FY09
where EBIT margins peaked (despite just 8% revenue growth), we expect
mgmt to strike a balance between utilizing levers and investing for future
growth. Hence, we largely retain our margin assumptions and reduce EPS
for the large caps by up to 15% for FY12E-FY14E. We roll forward our TPs
to FY13 and reduce them by 10-31% on lowered implied TP multiples.
Current prices reflect a more bearish 2012, pricing in 2008 déjà-vu
The Indian IT sector has underperformed the broader market by 10% (down
21%) in the last 3-months on above concerns. In our view, current market
prices are reflecting a 2008 déjà-vu, factoring in 10%-12% revenue growth
with headwinds to margins. In our view, this may be bearish vs. our midteen growth forecast and we believe stocks are offering better entry point.
Prefer HCL Tech and Infosys on limited downside, better valuations
We prefer HCL Tech (18%/19% revenue and EPS CAGR for FY11-FY13E)
and Infosys (limited downside on valuations) as our best Buy ideas and
reiterate Sell on Patni. We expect HCL to deliver 19% EPS CAGR over FY11-
FY13E on the back of higher deal wins. HCL is trading at 11.3x on FY13E
P/E, at a 25% discount to its historical average. On INFY, we expect 15%
EPS CAGR over FY11-FY13E, coupled with attractive valuations (14.6x on
FY13 P/E, at a 30% discount to its historical average) to re-rate the stock
Secular growth outlook remains intact despite macro concerns
We continue to believe that the secular growth story for the Indian IT outsourcing
companies is here to stay and remains intact despite multiple headwinds discussed above.
Hence, we forecast a healthy 17% and 13% revenue and EPS CAGR for the large cap
companies under our coverage for FY11-FY13E on the back of following reasons.
Management commentary remains positive for near term: Our discussions with all
the top Indian IT companies suggest that they have not seen any weakness in the
demand and no clients have gotten back to them with any concerns. All companies
unanimously confirmed a stable 2H2011, however, they did mention that 2012 looks
uncertain at this point of time. Hiring plans for all the companies are on track with no
slowing down and they will be going to the campuses for fresher offers for next year.
Offshoring is a measure to preserve margins: In times when the revenue growth for
corporates look weak, offshoring is one of the ways to preserve margins. Hence, in a
weaker outlook scenario, we may see corporate increasing their offshore mix to
preserve margins for a limited period of time.
Cost cut may not be ‘in’ IT but could be ‘through’ IT: Since 2008 crisis, major
corporates have taken a lot of cost cut initiatives to save costs in order to maintain
profitable growth. Hence, we believe that there is not much scope for the corporate to
keep cutting on costs and reduce IT budgets as it will start affecting the business
models. Hence, we do not see similar IT budget slashing for outsources as we
witnessed in 2008-09. However, we may see more vendor consolidation and vendor
churn towards companies which provide more work for the same dollar value.
Compliance work in the BFS segment may bring next leg of opportunities:
Regulatory compliance work like the Dodd Frank Act, Basel III implementation may
drive the next leg of growth for the Indian IT companies. Though the M&A integration
might be witnessing the tail end of the growth, regulatory compliance may continue
spending in the BFS corporate over the next 2-3 years considering the complexities of
the same. Companies are already trying to pre-empt the same by starting to spend on
preparing for the implementation of these regulations.
Currency is a balancer of growth: In 2008, despite single digit US$ revenue growth
(9% yoy), the reported revenue growth for Indian IT companies was 26% as INR
depreciated by more than 20%. So, the strength of USD/INR resulted in mitigating the
slowdown in revenue growth and helped cushion margin compression too. Hence, we
believe that a depreciating INR will be an upside risk in weaker global environments.
Our sensitivity (Exhibit 7) suggests that every Re1 change in INR/USD rate has about
4% sensitivity to EBIT and 3% sensitivity to EPS.
Reduced uncertainty may compel corporates to start investing again: Despite a
possibility of deferring their IT spends in case of a weaker outlook in 2012, we believe
that corporates could resume IT spending as soon as there is clarity on growth
resuming. We believe that S&P 500 companies with healthy balance sheets may look
towards investing in business and growth rather than holding it back once they have
any visibility on the economic environment. Hence, we believe we may see IT deals
picking up for Indian IT companies.
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