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What are stocks telling us about the future of the Indian IT sector? To get a
better sense of the view of the markets regarding the tech sector, we employ our
proprietary reverse DCF framework that sheds light on what expectations are
embedded in current valuations. This cuts out the noise and gives us concrete
signals for the future. Are Infosys/TCS being priced as perpetual 5-6% EPS
growth stories starting FY13? If not, how much further do they have to go?
~80% of the current market cap of Infosys/TCS constituted by terminal,
perpetual growth of 5% starting FY13. Our analysis reveals that Infosys’s
stock price at Rs 1,800-1,900 and TCS at Rs ~750 factor in 5% perpetual
growth story starting FY13 (this is on the back of a sharply slowing 2HFY12
which we have already built in). Simply put, at current prices, we estimate over
80% of the current market value of these stocks prices in 5% perpetual growth
(or less than 20% of current market-cap is attributable to above terminal-stage
growth). As a rule of thumb, 5% perpetual growth translates into a forward P/E
multiple of ~13x (also corroborated using the equation steady-state multiple = 1-
(g/ROIC)/(Cost of capital – g). Thus, P/E of 12-13x on FY13 should be a
signal telling the investor that Infosys/TCS are pricing in no more than 5%
growth to perpetuity starting FY13 (zero/no-growth multiple is 8-9x).
Push and Pull factors at play in Indian IT. “Push” refers to Indian IT selling
its existing value proposition to first time outsourcers (FTOs) and newer
verticals in times of economic turmoil such as today. For example, Cognizant
believes that despite huge economic uncertainty in Europe, the offshore
outsourcing proposition has achieved penetration of just 10% there. “Pull”
relates to Indian IT enhancing its value proposition through forays into cloud
computing, analytics, mobility, more sophisticated methods of complex program
management, productivity-based pricing etc. Much of the appeal associated with
the Pull factor was developed/solidified in the past three years. The silver lining
to the Lehman crisis was that Tier-1 stocks such as TCS/Infosys have expanded
addressable market since 2008 thanks to both the push and pull factors.
Admittedly, it is foolhardy to call the bottom but to extrapolate FY13 to
perpetuity may also overdo the pessimism surrounding Indian IT.
Recession or the scare of it tends to have an immediate and severe impact on
P/Es of blue-chip IT stocks such as TCS/ Infosys (also seen post-Lehman). To
be sure, we are not saying that there is unlikely to be further downside to current
valuations/stock prices. In times of recession, admittedly, it would be foolhardy
to call the bottom but it behooves us to do an analysis of what is priced in over
the medium-to-long term (beyond FY12/FY13). The bounce-back to peak
multiples that prevailed in the 4-5 months prior to the Lehman collapse was
attained in less than a year after the event. Whichever way we cut our analysis,
we find it difficult to paint a scenario in which Infosys/TCS grow in FY13 only
at single-digit %. 10% revenue growth in FY13E factors in four successive
quarters of very slow sequential growth starting Sep-Dec11. We believe that
Infosys/TCS stock should rebound ~20% from here over the next 9-12 months
as the environment stabilizes and as the P/E multiple normalizes. That said,
stock catalysts could be pushed out to the advantage of the long-term investor.
Introduction – what is the future telling us?
Fears of a 'double-dip' recession have re-emerged after the S&P downgrade of the
US sovereign rating and pronounced weakness in Europe. This fear has pummeled
Indian IT stocks. Infosys/TCS stock prices have declined more than 35%/25% from
their peak earlier this year. While FY13 could be a period of adjustment, it makes
sense, in our view, to ask whether growth concerns beyond FY13 in such business
models are justified.
Note: (We don’t try to call bottoms here as that is a futile exercise when fears of
recession take hold, but we try to assess the mid-to-long term growth assumptions
that current valuations build in for the front-line companies in the Indian IT sector.
Also, our view is that abnormally low valuations while possible are unlikely to stay.
So, it’s not about predicting downside or seeing the bottom.)
Four questions coming to the fore
What is the multiple at which Infosys/TCS prices imply that these
companies have reached the phase of terminal/perpetual growth rate of 5%
starting FY13?
What percentage of the current stock price is contributed by
perpetual/terminal growth starting FY13 or what (remaining) proportion
comes from (expected) above-perpetual growth rate phase?
How many years of above-terminal growth (of how much growth) are
factored in to the current stock prices of Infosys/TCS?
Why do we think double digit revenue growth in FY13 is possible for
Infosys/TCS in FY13 assuming a Lehman-like event does not take place?
Section A: Exploring steady state growth valuation….we
find that when stocks hit 13x one-year forward P/E they
price in 5% growth to perpetuity starting FY13
How much further downside do we see from here? In our view, this is a pointless
question as during recession or fear of recession, it is hard to predict downside as
sentiments immoderately weigh upon multiples. However, as witnessed in the last
downturn, we believe stock prices tend to track back to their intrinsic value as
business logic prevails and there is stabilization in the environment.
To assess what might be the theoretical downturn valuations for TCS/Infosys, we
assume perpetual/terminal growth rate of 5% starting FY13. The current long-term
global GDP growth forecasts are at 3-4% and we have seen historically that IT
spending grows at ~1.5 times the global GDP growth rate. Hence, 5% terminal
growth rate seems logical to us.
Importantly, we have assumed 3QFY12 Q/Q revenue growth to be half of our
current estimates and 4QFY12 revenues to be flat sequentially (0% growth
Q/Q). We have factored in an appropriate slowdown in 2HFY12.
We estimate the current value of Infosys/TCS stocks assuming terminal/perpetual
growth rate of 5% starting FY13 accounts for about 80% of current stock price (see
figures 1-3). Notably, 5% perpetual/terminal growth rate implies forward P/E
multiple of ~13x, while zero growth in earnings starting FY13 implies forward P/E
multiple of about 8x (about half of the current value). Stocks are currently trading at
16-17x forward multiple assuming a few more years of above-terminal growth rate.
Thus, P/E of 12-13x on FY13 should be the signal telling the investor that
Infosys/TCS are pricing in no more than 5% growth to perpetuity starting
FY13 (no-growth multiple is 8-9x). When such multiples are hit, stocks are
unlikely to stay at such multiples as the environment normalizes, in our view.
The pertinent consequent question is how many years of how much above-perpetuity
growth rate is in current valuations and for how long? We answer these in Section B.
Section B: We estimate current prices factor in 8-9 years of
10% earnings growth (starting FY13) or 3-4 years of 15%
growth and then perpetuity (5% growth)
Our analysis suggests that current stock price of Infosys and TCS incorporate 8-9
years of 10% growth rate or 3-4 years of 15% earnings growth starting FY13. We reiterate
that we have assumed 3QFY12 Q/Q revenue growth to be half of our current
estimate and 4Q FY12 revenues to be flat sequentially (0% growth Q/Q). About 20%
of current stock price of Infosys and TCS originate from this aboveterminal/
perpetual growth rate phase. Please refer to tables 2 and 3 to see various
combinations of growth rates and period.
Section C - Our bear case and terrible,
worst case explored in depth
We constructed a scenario analysis for TCS and Infosys building in the possibility
that revenue growth might come under pressure in the next 4-6 quarters (for 2Q
FY12 visibility is high). We have assumed two hypothetical scenarios – a bear case
and another terrible, worst case.
Bear-case scenario – 10% revenue (US$) growth in FY13E
In our bear-case scenario, we assume that revenue growth severely moderates in
FY13 (from the current run-rate), but demand remains stronger than in the last
downturn because of clients being better prepared to face weak macro conditions.
Notably, in FY10, immediately following the Lehman bankruptcy, TCS and
Infosys reported revenue growth of 5% and 3%, respectively. Considering that
this time, a downturn (if at all) is unlikely to be as acute in the absence of a Lehmanlike
event, 10% revenue growth is a reasonable assumption, in our view.
In our bear case, we assume revenue growth to be 10% in FY13 on the back of
significant 2H FY12 moderation. We estimate 3Q FY12 Q/Q revenue growth to
be half of our current estimate and 4Q FY12 revenues to be flat sequentially
(0% growth Q/Q). Further, we believe that Infosys’ and TCS’ operating margins
will decline only slightly because lower wage rises and various other levers such as
SG&A rationalization, employee pyramid, and a favorable exchange rate due to
likely slight Rupee depreciation should help to contain the margin downside.
Revenue revival is factored in 2H FY13 after four slow quarters, which we
believe is appropriately conservative in a bear-case scenario.
Please see Figures 5 and 6 for our estimated quarterly (US$) revenue growth
trajectory for 10% Y/Y revenue growth in FY13 for TCS and Infosys.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
What are stocks telling us about the future of the Indian IT sector? To get a
better sense of the view of the markets regarding the tech sector, we employ our
proprietary reverse DCF framework that sheds light on what expectations are
embedded in current valuations. This cuts out the noise and gives us concrete
signals for the future. Are Infosys/TCS being priced as perpetual 5-6% EPS
growth stories starting FY13? If not, how much further do they have to go?
~80% of the current market cap of Infosys/TCS constituted by terminal,
perpetual growth of 5% starting FY13. Our analysis reveals that Infosys’s
stock price at Rs 1,800-1,900 and TCS at Rs ~750 factor in 5% perpetual
growth story starting FY13 (this is on the back of a sharply slowing 2HFY12
which we have already built in). Simply put, at current prices, we estimate over
80% of the current market value of these stocks prices in 5% perpetual growth
(or less than 20% of current market-cap is attributable to above terminal-stage
growth). As a rule of thumb, 5% perpetual growth translates into a forward P/E
multiple of ~13x (also corroborated using the equation steady-state multiple = 1-
(g/ROIC)/(Cost of capital – g). Thus, P/E of 12-13x on FY13 should be a
signal telling the investor that Infosys/TCS are pricing in no more than 5%
growth to perpetuity starting FY13 (zero/no-growth multiple is 8-9x).
Push and Pull factors at play in Indian IT. “Push” refers to Indian IT selling
its existing value proposition to first time outsourcers (FTOs) and newer
verticals in times of economic turmoil such as today. For example, Cognizant
believes that despite huge economic uncertainty in Europe, the offshore
outsourcing proposition has achieved penetration of just 10% there. “Pull”
relates to Indian IT enhancing its value proposition through forays into cloud
computing, analytics, mobility, more sophisticated methods of complex program
management, productivity-based pricing etc. Much of the appeal associated with
the Pull factor was developed/solidified in the past three years. The silver lining
to the Lehman crisis was that Tier-1 stocks such as TCS/Infosys have expanded
addressable market since 2008 thanks to both the push and pull factors.
Admittedly, it is foolhardy to call the bottom but to extrapolate FY13 to
perpetuity may also overdo the pessimism surrounding Indian IT.
Recession or the scare of it tends to have an immediate and severe impact on
P/Es of blue-chip IT stocks such as TCS/ Infosys (also seen post-Lehman). To
be sure, we are not saying that there is unlikely to be further downside to current
valuations/stock prices. In times of recession, admittedly, it would be foolhardy
to call the bottom but it behooves us to do an analysis of what is priced in over
the medium-to-long term (beyond FY12/FY13). The bounce-back to peak
multiples that prevailed in the 4-5 months prior to the Lehman collapse was
attained in less than a year after the event. Whichever way we cut our analysis,
we find it difficult to paint a scenario in which Infosys/TCS grow in FY13 only
at single-digit %. 10% revenue growth in FY13E factors in four successive
quarters of very slow sequential growth starting Sep-Dec11. We believe that
Infosys/TCS stock should rebound ~20% from here over the next 9-12 months
as the environment stabilizes and as the P/E multiple normalizes. That said,
stock catalysts could be pushed out to the advantage of the long-term investor.
Introduction – what is the future telling us?
Fears of a 'double-dip' recession have re-emerged after the S&P downgrade of the
US sovereign rating and pronounced weakness in Europe. This fear has pummeled
Indian IT stocks. Infosys/TCS stock prices have declined more than 35%/25% from
their peak earlier this year. While FY13 could be a period of adjustment, it makes
sense, in our view, to ask whether growth concerns beyond FY13 in such business
models are justified.
Note: (We don’t try to call bottoms here as that is a futile exercise when fears of
recession take hold, but we try to assess the mid-to-long term growth assumptions
that current valuations build in for the front-line companies in the Indian IT sector.
Also, our view is that abnormally low valuations while possible are unlikely to stay.
So, it’s not about predicting downside or seeing the bottom.)
Four questions coming to the fore
What is the multiple at which Infosys/TCS prices imply that these
companies have reached the phase of terminal/perpetual growth rate of 5%
starting FY13?
What percentage of the current stock price is contributed by
perpetual/terminal growth starting FY13 or what (remaining) proportion
comes from (expected) above-perpetual growth rate phase?
How many years of above-terminal growth (of how much growth) are
factored in to the current stock prices of Infosys/TCS?
Why do we think double digit revenue growth in FY13 is possible for
Infosys/TCS in FY13 assuming a Lehman-like event does not take place?
Section A: Exploring steady state growth valuation….we
find that when stocks hit 13x one-year forward P/E they
price in 5% growth to perpetuity starting FY13
How much further downside do we see from here? In our view, this is a pointless
question as during recession or fear of recession, it is hard to predict downside as
sentiments immoderately weigh upon multiples. However, as witnessed in the last
downturn, we believe stock prices tend to track back to their intrinsic value as
business logic prevails and there is stabilization in the environment.
To assess what might be the theoretical downturn valuations for TCS/Infosys, we
assume perpetual/terminal growth rate of 5% starting FY13. The current long-term
global GDP growth forecasts are at 3-4% and we have seen historically that IT
spending grows at ~1.5 times the global GDP growth rate. Hence, 5% terminal
growth rate seems logical to us.
Importantly, we have assumed 3QFY12 Q/Q revenue growth to be half of our
current estimates and 4QFY12 revenues to be flat sequentially (0% growth
Q/Q). We have factored in an appropriate slowdown in 2HFY12.
We estimate the current value of Infosys/TCS stocks assuming terminal/perpetual
growth rate of 5% starting FY13 accounts for about 80% of current stock price (see
figures 1-3). Notably, 5% perpetual/terminal growth rate implies forward P/E
multiple of ~13x, while zero growth in earnings starting FY13 implies forward P/E
multiple of about 8x (about half of the current value). Stocks are currently trading at
16-17x forward multiple assuming a few more years of above-terminal growth rate.
Thus, P/E of 12-13x on FY13 should be the signal telling the investor that
Infosys/TCS are pricing in no more than 5% growth to perpetuity starting
FY13 (no-growth multiple is 8-9x). When such multiples are hit, stocks are
unlikely to stay at such multiples as the environment normalizes, in our view.
The pertinent consequent question is how many years of how much above-perpetuity
growth rate is in current valuations and for how long? We answer these in Section B.
Section B: We estimate current prices factor in 8-9 years of
10% earnings growth (starting FY13) or 3-4 years of 15%
growth and then perpetuity (5% growth)
Our analysis suggests that current stock price of Infosys and TCS incorporate 8-9
years of 10% growth rate or 3-4 years of 15% earnings growth starting FY13. We reiterate
that we have assumed 3QFY12 Q/Q revenue growth to be half of our current
estimate and 4Q FY12 revenues to be flat sequentially (0% growth Q/Q). About 20%
of current stock price of Infosys and TCS originate from this aboveterminal/
perpetual growth rate phase. Please refer to tables 2 and 3 to see various
combinations of growth rates and period.
Section C - Our bear case and terrible,
worst case explored in depth
We constructed a scenario analysis for TCS and Infosys building in the possibility
that revenue growth might come under pressure in the next 4-6 quarters (for 2Q
FY12 visibility is high). We have assumed two hypothetical scenarios – a bear case
and another terrible, worst case.
Bear-case scenario – 10% revenue (US$) growth in FY13E
In our bear-case scenario, we assume that revenue growth severely moderates in
FY13 (from the current run-rate), but demand remains stronger than in the last
downturn because of clients being better prepared to face weak macro conditions.
Notably, in FY10, immediately following the Lehman bankruptcy, TCS and
Infosys reported revenue growth of 5% and 3%, respectively. Considering that
this time, a downturn (if at all) is unlikely to be as acute in the absence of a Lehmanlike
event, 10% revenue growth is a reasonable assumption, in our view.
In our bear case, we assume revenue growth to be 10% in FY13 on the back of
significant 2H FY12 moderation. We estimate 3Q FY12 Q/Q revenue growth to
be half of our current estimate and 4Q FY12 revenues to be flat sequentially
(0% growth Q/Q). Further, we believe that Infosys’ and TCS’ operating margins
will decline only slightly because lower wage rises and various other levers such as
SG&A rationalization, employee pyramid, and a favorable exchange rate due to
likely slight Rupee depreciation should help to contain the margin downside.
Revenue revival is factored in 2H FY13 after four slow quarters, which we
believe is appropriately conservative in a bear-case scenario.
Please see Figures 5 and 6 for our estimated quarterly (US$) revenue growth
trajectory for 10% Y/Y revenue growth in FY13 for TCS and Infosys.
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