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Demand moderation in FY13F, but no falling off the cliff
We see revenue growth in FY13F moderating to low-teen levels from our
estimated 22% in FY12F for Tier-1 IT companies, largely on clients’
decision-making inertia and not structural impairment of demand. Cost
moderation, pricing stability and rupee depreciation will however take EPS
growth to 15%, ahead of revenue growth in FY13F, on our estimates.
Tier-1 IT growth: Shift in IT spend allocations and simple economics
to power revenue growth closer to trendline
Our analysis suggests that the flow business is likely to support just half of
the historical industry growth rate. However, we believe Tier-1 IT players
will grow faster, at the expense of local players/MNC incumbents as trends
of increasing: 1) consolidation; 2) offshore penetration; 3) productization;
and 4) pervasiveness of technology play to their advantage. Clients'
inability to fund skill up-gradation of their local/captive tech workforce, as
well as macro-driven cost constraints, increase the attractiveness of
offshore outsourcing, in our view. We estimate Tier-1 IT revenue growth
will rebound to ~18% in FY14F as the speed of decision-making improves.
Action: Buy HCLT/INFO; Raise CTSH to Buy; iGATE: top Tier-2 pick
We believe buying into perceived risk and/or high pessimism (INFO, HCLT,
CTSH) will generate higher returns than buying into consensus favourites
(TCS, WPRO). We see HCLT gaining market share in a consolidating /
under-penetrated environment, and benefiting from the resumption of
productization spending. We upgrade CTSH to Buy on it benefiting from
consolidation/increased regulation spending trends given higher
reinvestments and client connect. INFO appears well-positioned for a
rebound when productization and pervasiveness of technology (BFSI
regulation spending) resume from 2HFY13F. At Wipro, the turnaround pace
is likely to disappoint investors; while TCS, despite continuing to outperform
peers, will likely see limited upside due to expensive valuations.
Valuation hit unlikely in near term; MNC outperformance may reverse
We expect Tier-1 IT firms to perform better than multi-national company
(MNC) IT players (e.g., Accenture/IBM), as clients shift towards higher
offshore delivery to save costs and rupee depreciation benefits India IT
firms more than MNCs.
Demand moderation in FY13F, but no falling off the cliff; we expect a rebound in
2HFY13F
Given current economic uncertainties, we see a slowdown in demand in FY13F, and
estimate growth to drop to low-teens percentage vs ~22% in FY12F for Tier-1 IT
companies. However, we believe this is likely to be just a temporary blip in a continuing
growth story for the Tier-1 IT companies. We attribute the likely demand softness to
decision-making inertia and not to any structural impairment in demand. In this scenario,
we expect growth to rebound to ~18% in FY14F as the speed of decision-making
improves. We believe our FY13F revenue growth estimates are likely to be met, even in
a scenario of flattish growth in Europe, with growth largely contributed by the rest of the
world (ROW) and the US. We expect cost moderation, relative pricing stability and rupee
depreciation to more than offset the revenue slowdown impact, with Tier-1 IT companies’
earnings growing ahead of revenues in FY13F.
No stopping Tier-1 IT growth: Shift in IT spend allocations and simple economics
likely to power revenue growth closer to trend line growth
Our analysis, which is based on headcount additions in computer-related occupations in
the US and Europe and their associated offshore headcount additions, suggests that the
flow business is likely to support just half of the historical industry growth of 24% over the
past seven years. In our flow business model, we do not factor change in slope of
outsourcing or increased technology adoption, which might push growth higher.
Favourable trends like increasing 1) consolidation; 2) offshore penetration; 3)
productization; and 4) pervasiveness of technology which will play to the advantage of
Tier-1 IT and enable them to expand faster at the expense of local players/MNC
incumbents. Clients' inability to fund the skill up-gradation of their local/captive tech
workforce, as well as macro-driven cost constraints, increases the attractiveness of
offshore outsourcing.
Buy into perceived risk and not defensive plays
We believe buying into perceived risk and/or high pessimism (HCLT,INFO,CTSH) is
likely to generate outlier returns, while stocks that the Street perceives as defensive
plays are likely to generate limited upsides (TCS) or turn into risky investments (Wipro).
We upgrade CTSH to Buy on it benefiting from consolidation/increased regulation
spending trends given higher reinvestments and client connect. We believe that HCL
Tech straddles both market-share gains in consolidation/under-penetration scenarios
and potential upside from a productization revival. Margin sustainability concerns are
unfounded, in our view, and best-in-class earnings growth is likely to result in stock rerating.
Infosys, in our view, should post growth that is comparable to that of its peer
group over the next two quarters and we believe it is well positioned for a rebound on a
revival in productization and the increasing pervasiveness of technology (BFSI regulation
spending) from 2HFY13F. In our opinion, the Street’s current pessimism has not factored
in these possibilities. In that light, while we like TCS for its ability to gain from all the
underlying trends, but heightened Street expectations and limited scope for positive
surprises make us cautious on the stock. At Wipro, we believe the turnaround pace is
likely to disappoint investors; we expect its revenue and earnings to continue to lag that
of its peers.
Near term valuation hit unlikely; MNC outperformance may reverse
Current valuations are at a discount of 10% vs historical averages. We believe investors’
concerns of valuation multiples structurally correcting are unlikely to play out in the near
term as growth moderation is temporary and margin structures remain viable.
In addition, MNC players such as IBM and Accenture outperformed India’s Tier-1 IT
names by 20-40% in 2011, and we expect the Tier-1 IT companies to perform better as:
1) they exhibit greater revenue defensiveness than MNCs, for which there is a risk of
onsite revenue cannibalisation towards offshore and a higher dependence on consulting
(first to be hit during a downturn); 2) rupee depreciation benefits India ITs more than
MNCs; and 3) MNC valuation discounts to Tier-1 ITs could widen on higher revenue
volatility.
Key conclusions from our analysis
• We expect the ROW to contribute at least 4-5% y-y growth in FY13F, even if the growth
rate halves from current levels of ~40% (LTM y-y). The ROW currently contributes ~20-
30% of the incremental growth for Tier-1 companies and has grown at ~40% y-y on an
LTM basis.
• We expect the US to show double-digit-percentage growth and contribute at least 7-8%
y-y to the overall growth in FY13F. Our analysis on US economic data, tech
unemployment trends and US Fortune 500 profitability are key determinants to our
view.
• Europe uncertainty would remain and we do expect decision-making to suffer in the
near term. However, we believe core European business out of the UK (two-thirds of
India IT European exposure) is likely to be less impacted and in France/Germany
penetration seems too low to be a concern. We see significant account openings in
Europe during FY13F as Europe looks more seriously at offshoring to cut costs in an
uncertain revenue environment. Our mid-teen-percentage revenue growth projections
for FY13F are building in flattish growth expectations in Europe. Increased traction on
new account openings and offshoring in Europe could provide upside to our estimates.
Prefer the rebound candidates, where
expectations are low
We believe buying into perceived risk and/or high pessimism (HCLT,INFO,CTSH) is
likely to generate outlier returns, while stocks that the Street perceives as defensive
plays are likely to generate limited upsides (TCS) or turn into risky investments (Wipro).
We upgrade CTSH to Buy on it benefiting from consolidation/increased regulation
spending trends given higher reinvestments and client connect. We believe that HCL
Tech straddles both market-share gains in consolidation/under-penetration scenarios
and potential upside from a productization revival. Margin sustainability concerns are
unfounded, in our view, and best-in-class earnings growth is likely to result in stock rerating.
Infosys, in our view, should post growth that is comparable to that of its peer
group over the next two quarters and we believe it is well positioned for a rebound on a
revival in productization and the increasing pervasiveness of technology (BFSI regulation
spending) from 2HFY13F. In our opinion, the Street’s current pessimism has not factored
in these possibilities. In that light, while we like TCS for its ability to gain from all the
underlying trends, but heightened Street expectations and limited scope for positive
surprises make us cautious on the stock. At Wipro, we believe the turnaround pace is
likely to disappoint investors; we expect its revenue and earnings to continue to lag that
of its peers.
Greater pessimism built into HCL Tech, Cognizant and Infosys
Infosys’ cautious comments, reduced growth expectations and lacklustre performance in
business operations have led the Street to believe that the company has structural
issues. Consensus target prices at Infosys have dropped over the last three months and
recent downgrades from the Street indicate to us a sense of increased pessimism. This
pessimism is partly reflected in its valuation, where it trades at a 10% discount to TCS’
vs the historical premium of ~10%. Similarly at HCL Tech, the Street is concerned over
its limited revenue outperformance in the recent past compared to its Tier-1 peers,
despite having a lower margin profile and management indicating limited upside to
margins, even in a rupee depreciation scenario. At Cognizant too, we believe the
correction in valuation multiples from 26x 1-yr forward at the beginning of 2011 to ~19x
currently, suggests attribution of higher risks by the street.
Contrary to this, the more upbeat commentary at TCS and the outperformance in
revenue growth have led to consensus TP upgrades and significant future growth
expectations being built into valuations. At Wipro, post the last quarter performance,
consensus hopes of a speedy return to comparable growth vs Tier-1 peers have led to
recent consensus TP upgrades and greater optimism.
Stock picks in order of preference
• HCL Tech: HCL Tech remains our top pick in Tier-1 IT names, as it: 1) straddles both
market-share gains in RTB on strengths in IMS and potential upside from a CTB revival
given its large engineering services practise and strong SAP consulting capabilities; 2)
its market-share gain focus against MNC players and historical high deal pipeline in the
Dec-11 quarter provide comfort on near-term growth; and 3) we find greater comfort in
its margin stability and inexpensive valuations in light of its best-in-class earnings
growth across Tier-1 universe. Reaffirm Buy.
• Cognizant: We believe Cognizant will continue to outperform its Tier-1 IT peers in
revenue growth, driven by its 1) recession- proof healthcare business and closer client
connect in BFSI and 2) gains from consolidation trends given its higher reinvestment
focus. The stock’s valuation has corrected from 26x to 19x 1-yr forward earnings in
2011, despite better-than-peer group performance. Given the anticipated growth
outperformance vs peers, we find the current valuation of 10% premium over Infosys
(vs historical premium of ~20%) attractive. Upgrade to Buy.
• Infosys: We believe Infosys is best positioned for a rebound as productization spends
and a shift in client spending patterns towards change the business/regulation spends
start playing out from 2HFY13F onwards. Contrary to consensus, we believe that
Infosys’ troubles are not structural, but more environment-led. In the near-term, too, we
believe Infosys would post par growth along with peers such as TCS (much more
upbeat on commentary); this coupled with bigger potential gains from rupee
depreciation and low expectations built into valuations makes us positive on the stock.
Reaffirm Buy.
• iGATE: It remains our top Tier-2 IT pick on account of our expectations of high
operating leverage, leading to potential improvement in margins over the next two
years. Moreover, with revenue synergies of Patni acquisition not yet built into
estimates, this could provide upside. iGate’s best-in-class earnings growth potential
and mitigation of debt overhangs over the next two years makes us positive on the
stock. Reaffirm Buy.
• TCS: While we like TCS for its potential to drive market-share gains in view of its widest
vertical, service line and geographical presence across Tier-1 IT companies and recent
momentum, we believe disappointments are likely in the interim on any commentary
moderation, given high expectations built into its current valuations. We would await
such disappointments to play out before revisiting our call. Maintain Neutral.
• Wipro: We believe the stock price rise over the past three months is driven by hopes of
a speedy revenue growth revival. There could be disappointments in store on this count
with the lag in revenue and earnings growth continuing and valuations staying
depressed as the balance sheet improvements might not be forthcoming, in our view.
We maintain Neutral and reiterate least preference for Wipro among Tier 1 IT stocks.
We believe company valuations are unlikely to structurally correct significantly from
historical average levels, as the margin structures are sustainable and as growth
rebound takes shape to get closer to trendline growth in FY14F. Our target multiples for
these stocks are already 10-15% lower compared to historical averages and take into
account the growth moderation from historical levels.
We like the defensiveness of IT services in the tech segment
We like the defensiveness of IT services in a slowing environment. This was seen during
the last downturn when hardware capex, followed by software capex and consulting, was
most impacted and yet Tier-1 IT names continued to post growth. Likewise, in a
recovering scenario, growth of Tier-1 IT services saw a sharper rebound compared with
segments such as hardware, software or consulting. The defensiveness of Tier-1 IT
names is also seen in Oracle/SAP application license growth vs. Tier-1 IT growth, where
the former usually shows a sharper correction in a slowing environment. Likewise, in this
current downturn, we expect the same defensiveness and believe the revenue of Tier-1
IT services will largely remain in double-digit-percentage growth trajectory. Lesser
exposure to consulting should help cushion the fall in revenue growth of Tier- 1 IT
names, in our view.
Case for reversal of preference for MNC over Indian IT players
MNC players such as Accenture and IBM outperformed the Indian IT players by ~30-
50% in 2011, driven by:
• Investors’ view that as cannibalization of onsite revenues decreases and offshore
proportions increase for these players, growth would look better
• As offshore proportions increase, these companies would show consistent margin
increases vs anticipated margin declines at Tier-1 IT progressively.
• Significant valuation discounts to Tier-1 IT names
We believe there could be a case for this preference to start shifting towards the more
reasonably valued India’s Tier-1 IT players as:
• Valuation discounts of MNCs vs the Indian Tier-1 IT players are inline with historical
averages and these discount could widen if revenue growth of MNC’s shows greater
volatility compared with Indian IT.
• Current economic conditions could create similar push factors like during the last
downturn, when MNCs showed sharper declines in revenue growth. This is on account
of: 1) accelerating cannibalization of onsite revenues as clients look to cut costs; 2) the
business cycle of consulting is one that usually gets affected first because of downturns
and consulting exposure of MNC players such as IBM and Accenture is higher
compared to India’s Tier-1 IT companies, which are more outsourcing focused.
3QFY12F preview
In our report “More pain or scope to gain”, September 2011, we had cautioned that
Indian IT companies would start to warn about demand deterioration from 3QFY12F and
that revenues would start to feel the impact of the slowdown from 4QFY12F. Indeed, this
has already started to happen, with cautious commentary from: 1) Infosys, which warned
about delays in decision-making and deterioration from the previous quarter; and 2) Tech
Mahindra and HCL Tech, which announced that the demand for discretionary has dried
up. In our opinion, 3QFY12F results will likely reveal moderating revenues, due to: 1)
clients conserving cash ahead of the year-end closing, especially for discretionary
projects; 2) seasonal weakness on account of lower billing days and shutdowns; and 3)
adverse impact on revenue growth of Tier-1 IT companies from cross currency
movements. We expect Infosys and TCS to give different comments but to post largely
similar revenue growth.
Results expectations
• We expect the Indian Tier-1 IT companies to post USD revenue growth of between
2.5% and 3.5% q-q in 3QFY12F with Infosys’ at the lower end of its guidance (3.2-5.4%
q-q) and TCS posting similar revenue growth as Infosys. We expect Cognizant to be
ahead of guidance at 4.7% q-q (vs guidance of 3.7%)
• Higher benefits would be seen at Infosys and TCS on margins due to rupee
depreciation. Cognizant is unlikely to see material rupee depreciation-related margin
positives given its higher hedging. We expect EBITDA margin improvements of
between 70-250bps across the Tier-1 IT companies (except for Cognizant), with the
lowest benefits at HCL Tech and highest at Infosys.
• Below the operating line, we believe impacts are likely to be divergent based on
hedging levels, with Infosys being the least affected by forex losses among the Tier-1
IT names, while TCS, Wipro and HCL Tech would get hurt more given their higher
hedging levels.
Key things to watch out for
• Cognizant’s FY12F revenue growth guidance would, in our view, offer the first peek into
the demand for IT services in calendar year 2012. We expect Cognizant to guide for at
least 21% growth - within the 18-23% range indicated by the company in its 8-K filing
for 50-100% vesting of its senior management’s restricted stock options (RSU).
• Infosys’ FY12F revenue growth guidance may be revised down marginally, in our view,
as its 3Q revenues might be closer to the lower end of its guidance, making it difficult to
achieve the higher-end of its revenue growth guidance of 17-19%. The likely change in
guidance for FY12F, in our view, would be driven by headwinds such as decisionmaking
delays, clients’ holding back on budgets and adverse cross currency impacts.
• At Wipro, we believe its next quarter revenue growth guidance needs to be closely
monitored, especially after its above-expectation guidance for 3Q. This should indicate
to us whether Wipro is able to sustain its revenue growth recovery. Lower-than-3% q-q
growth guidance (for 4QFY12F) would be taken negatively, in our view.
• HCL Tech’s deal announcements, amid expectations of a strong deal-signing quarter,
will be another key event to watch out for, in our view.
Result plays
• Despite divergent commentary, we expect Infosys and TCS to show similar revenue
growths in 3QFY12F - similar to the previous quarter. Hence, we would recommend to
Buy Infosys, where the Street’s expectations are low and earnings growth would likely
be higher than TCS, on account of lower forex losses.
• Wipro is one stock that we believe the risks of disappointment are highest among the
Indian IT companies, as expectations of a revenue growth recovery have been built
and failure to materialise is likely to lead to a negative stock price reaction, especially
given that the stock has outperformed the Nifty by 22% over the past 3 months.
• Among Tier-2 IT names, we are positively inclined towards iGATE, which remains our
top Tier-2 pick in the sector. We expect it to see positive progress on closing the gap
with its stated EBITDA margin guidance of 25% by June 2013.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Demand moderation in FY13F, but no falling off the cliff
We see revenue growth in FY13F moderating to low-teen levels from our
estimated 22% in FY12F for Tier-1 IT companies, largely on clients’
decision-making inertia and not structural impairment of demand. Cost
moderation, pricing stability and rupee depreciation will however take EPS
growth to 15%, ahead of revenue growth in FY13F, on our estimates.
Tier-1 IT growth: Shift in IT spend allocations and simple economics
to power revenue growth closer to trendline
Our analysis suggests that the flow business is likely to support just half of
the historical industry growth rate. However, we believe Tier-1 IT players
will grow faster, at the expense of local players/MNC incumbents as trends
of increasing: 1) consolidation; 2) offshore penetration; 3) productization;
and 4) pervasiveness of technology play to their advantage. Clients'
inability to fund skill up-gradation of their local/captive tech workforce, as
well as macro-driven cost constraints, increase the attractiveness of
offshore outsourcing, in our view. We estimate Tier-1 IT revenue growth
will rebound to ~18% in FY14F as the speed of decision-making improves.
Action: Buy HCLT/INFO; Raise CTSH to Buy; iGATE: top Tier-2 pick
We believe buying into perceived risk and/or high pessimism (INFO, HCLT,
CTSH) will generate higher returns than buying into consensus favourites
(TCS, WPRO). We see HCLT gaining market share in a consolidating /
under-penetrated environment, and benefiting from the resumption of
productization spending. We upgrade CTSH to Buy on it benefiting from
consolidation/increased regulation spending trends given higher
reinvestments and client connect. INFO appears well-positioned for a
rebound when productization and pervasiveness of technology (BFSI
regulation spending) resume from 2HFY13F. At Wipro, the turnaround pace
is likely to disappoint investors; while TCS, despite continuing to outperform
peers, will likely see limited upside due to expensive valuations.
Valuation hit unlikely in near term; MNC outperformance may reverse
We expect Tier-1 IT firms to perform better than multi-national company
(MNC) IT players (e.g., Accenture/IBM), as clients shift towards higher
offshore delivery to save costs and rupee depreciation benefits India IT
firms more than MNCs.
Demand moderation in FY13F, but no falling off the cliff; we expect a rebound in
2HFY13F
Given current economic uncertainties, we see a slowdown in demand in FY13F, and
estimate growth to drop to low-teens percentage vs ~22% in FY12F for Tier-1 IT
companies. However, we believe this is likely to be just a temporary blip in a continuing
growth story for the Tier-1 IT companies. We attribute the likely demand softness to
decision-making inertia and not to any structural impairment in demand. In this scenario,
we expect growth to rebound to ~18% in FY14F as the speed of decision-making
improves. We believe our FY13F revenue growth estimates are likely to be met, even in
a scenario of flattish growth in Europe, with growth largely contributed by the rest of the
world (ROW) and the US. We expect cost moderation, relative pricing stability and rupee
depreciation to more than offset the revenue slowdown impact, with Tier-1 IT companies’
earnings growing ahead of revenues in FY13F.
No stopping Tier-1 IT growth: Shift in IT spend allocations and simple economics
likely to power revenue growth closer to trend line growth
Our analysis, which is based on headcount additions in computer-related occupations in
the US and Europe and their associated offshore headcount additions, suggests that the
flow business is likely to support just half of the historical industry growth of 24% over the
past seven years. In our flow business model, we do not factor change in slope of
outsourcing or increased technology adoption, which might push growth higher.
Favourable trends like increasing 1) consolidation; 2) offshore penetration; 3)
productization; and 4) pervasiveness of technology which will play to the advantage of
Tier-1 IT and enable them to expand faster at the expense of local players/MNC
incumbents. Clients' inability to fund the skill up-gradation of their local/captive tech
workforce, as well as macro-driven cost constraints, increases the attractiveness of
offshore outsourcing.
Buy into perceived risk and not defensive plays
We believe buying into perceived risk and/or high pessimism (HCLT,INFO,CTSH) is
likely to generate outlier returns, while stocks that the Street perceives as defensive
plays are likely to generate limited upsides (TCS) or turn into risky investments (Wipro).
We upgrade CTSH to Buy on it benefiting from consolidation/increased regulation
spending trends given higher reinvestments and client connect. We believe that HCL
Tech straddles both market-share gains in consolidation/under-penetration scenarios
and potential upside from a productization revival. Margin sustainability concerns are
unfounded, in our view, and best-in-class earnings growth is likely to result in stock rerating.
Infosys, in our view, should post growth that is comparable to that of its peer
group over the next two quarters and we believe it is well positioned for a rebound on a
revival in productization and the increasing pervasiveness of technology (BFSI regulation
spending) from 2HFY13F. In our opinion, the Street’s current pessimism has not factored
in these possibilities. In that light, while we like TCS for its ability to gain from all the
underlying trends, but heightened Street expectations and limited scope for positive
surprises make us cautious on the stock. At Wipro, we believe the turnaround pace is
likely to disappoint investors; we expect its revenue and earnings to continue to lag that
of its peers.
Near term valuation hit unlikely; MNC outperformance may reverse
Current valuations are at a discount of 10% vs historical averages. We believe investors’
concerns of valuation multiples structurally correcting are unlikely to play out in the near
term as growth moderation is temporary and margin structures remain viable.
In addition, MNC players such as IBM and Accenture outperformed India’s Tier-1 IT
names by 20-40% in 2011, and we expect the Tier-1 IT companies to perform better as:
1) they exhibit greater revenue defensiveness than MNCs, for which there is a risk of
onsite revenue cannibalisation towards offshore and a higher dependence on consulting
(first to be hit during a downturn); 2) rupee depreciation benefits India ITs more than
MNCs; and 3) MNC valuation discounts to Tier-1 ITs could widen on higher revenue
volatility.
Key conclusions from our analysis
• We expect the ROW to contribute at least 4-5% y-y growth in FY13F, even if the growth
rate halves from current levels of ~40% (LTM y-y). The ROW currently contributes ~20-
30% of the incremental growth for Tier-1 companies and has grown at ~40% y-y on an
LTM basis.
• We expect the US to show double-digit-percentage growth and contribute at least 7-8%
y-y to the overall growth in FY13F. Our analysis on US economic data, tech
unemployment trends and US Fortune 500 profitability are key determinants to our
view.
• Europe uncertainty would remain and we do expect decision-making to suffer in the
near term. However, we believe core European business out of the UK (two-thirds of
India IT European exposure) is likely to be less impacted and in France/Germany
penetration seems too low to be a concern. We see significant account openings in
Europe during FY13F as Europe looks more seriously at offshoring to cut costs in an
uncertain revenue environment. Our mid-teen-percentage revenue growth projections
for FY13F are building in flattish growth expectations in Europe. Increased traction on
new account openings and offshoring in Europe could provide upside to our estimates.
Prefer the rebound candidates, where
expectations are low
We believe buying into perceived risk and/or high pessimism (HCLT,INFO,CTSH) is
likely to generate outlier returns, while stocks that the Street perceives as defensive
plays are likely to generate limited upsides (TCS) or turn into risky investments (Wipro).
We upgrade CTSH to Buy on it benefiting from consolidation/increased regulation
spending trends given higher reinvestments and client connect. We believe that HCL
Tech straddles both market-share gains in consolidation/under-penetration scenarios
and potential upside from a productization revival. Margin sustainability concerns are
unfounded, in our view, and best-in-class earnings growth is likely to result in stock rerating.
Infosys, in our view, should post growth that is comparable to that of its peer
group over the next two quarters and we believe it is well positioned for a rebound on a
revival in productization and the increasing pervasiveness of technology (BFSI regulation
spending) from 2HFY13F. In our opinion, the Street’s current pessimism has not factored
in these possibilities. In that light, while we like TCS for its ability to gain from all the
underlying trends, but heightened Street expectations and limited scope for positive
surprises make us cautious on the stock. At Wipro, we believe the turnaround pace is
likely to disappoint investors; we expect its revenue and earnings to continue to lag that
of its peers.
Greater pessimism built into HCL Tech, Cognizant and Infosys
Infosys’ cautious comments, reduced growth expectations and lacklustre performance in
business operations have led the Street to believe that the company has structural
issues. Consensus target prices at Infosys have dropped over the last three months and
recent downgrades from the Street indicate to us a sense of increased pessimism. This
pessimism is partly reflected in its valuation, where it trades at a 10% discount to TCS’
vs the historical premium of ~10%. Similarly at HCL Tech, the Street is concerned over
its limited revenue outperformance in the recent past compared to its Tier-1 peers,
despite having a lower margin profile and management indicating limited upside to
margins, even in a rupee depreciation scenario. At Cognizant too, we believe the
correction in valuation multiples from 26x 1-yr forward at the beginning of 2011 to ~19x
currently, suggests attribution of higher risks by the street.
Contrary to this, the more upbeat commentary at TCS and the outperformance in
revenue growth have led to consensus TP upgrades and significant future growth
expectations being built into valuations. At Wipro, post the last quarter performance,
consensus hopes of a speedy return to comparable growth vs Tier-1 peers have led to
recent consensus TP upgrades and greater optimism.
Stock picks in order of preference
• HCL Tech: HCL Tech remains our top pick in Tier-1 IT names, as it: 1) straddles both
market-share gains in RTB on strengths in IMS and potential upside from a CTB revival
given its large engineering services practise and strong SAP consulting capabilities; 2)
its market-share gain focus against MNC players and historical high deal pipeline in the
Dec-11 quarter provide comfort on near-term growth; and 3) we find greater comfort in
its margin stability and inexpensive valuations in light of its best-in-class earnings
growth across Tier-1 universe. Reaffirm Buy.
• Cognizant: We believe Cognizant will continue to outperform its Tier-1 IT peers in
revenue growth, driven by its 1) recession- proof healthcare business and closer client
connect in BFSI and 2) gains from consolidation trends given its higher reinvestment
focus. The stock’s valuation has corrected from 26x to 19x 1-yr forward earnings in
2011, despite better-than-peer group performance. Given the anticipated growth
outperformance vs peers, we find the current valuation of 10% premium over Infosys
(vs historical premium of ~20%) attractive. Upgrade to Buy.
• Infosys: We believe Infosys is best positioned for a rebound as productization spends
and a shift in client spending patterns towards change the business/regulation spends
start playing out from 2HFY13F onwards. Contrary to consensus, we believe that
Infosys’ troubles are not structural, but more environment-led. In the near-term, too, we
believe Infosys would post par growth along with peers such as TCS (much more
upbeat on commentary); this coupled with bigger potential gains from rupee
depreciation and low expectations built into valuations makes us positive on the stock.
Reaffirm Buy.
• iGATE: It remains our top Tier-2 IT pick on account of our expectations of high
operating leverage, leading to potential improvement in margins over the next two
years. Moreover, with revenue synergies of Patni acquisition not yet built into
estimates, this could provide upside. iGate’s best-in-class earnings growth potential
and mitigation of debt overhangs over the next two years makes us positive on the
stock. Reaffirm Buy.
• TCS: While we like TCS for its potential to drive market-share gains in view of its widest
vertical, service line and geographical presence across Tier-1 IT companies and recent
momentum, we believe disappointments are likely in the interim on any commentary
moderation, given high expectations built into its current valuations. We would await
such disappointments to play out before revisiting our call. Maintain Neutral.
• Wipro: We believe the stock price rise over the past three months is driven by hopes of
a speedy revenue growth revival. There could be disappointments in store on this count
with the lag in revenue and earnings growth continuing and valuations staying
depressed as the balance sheet improvements might not be forthcoming, in our view.
We maintain Neutral and reiterate least preference for Wipro among Tier 1 IT stocks.
We believe company valuations are unlikely to structurally correct significantly from
historical average levels, as the margin structures are sustainable and as growth
rebound takes shape to get closer to trendline growth in FY14F. Our target multiples for
these stocks are already 10-15% lower compared to historical averages and take into
account the growth moderation from historical levels.
We like the defensiveness of IT services in the tech segment
We like the defensiveness of IT services in a slowing environment. This was seen during
the last downturn when hardware capex, followed by software capex and consulting, was
most impacted and yet Tier-1 IT names continued to post growth. Likewise, in a
recovering scenario, growth of Tier-1 IT services saw a sharper rebound compared with
segments such as hardware, software or consulting. The defensiveness of Tier-1 IT
names is also seen in Oracle/SAP application license growth vs. Tier-1 IT growth, where
the former usually shows a sharper correction in a slowing environment. Likewise, in this
current downturn, we expect the same defensiveness and believe the revenue of Tier-1
IT services will largely remain in double-digit-percentage growth trajectory. Lesser
exposure to consulting should help cushion the fall in revenue growth of Tier- 1 IT
names, in our view.
Case for reversal of preference for MNC over Indian IT players
MNC players such as Accenture and IBM outperformed the Indian IT players by ~30-
50% in 2011, driven by:
• Investors’ view that as cannibalization of onsite revenues decreases and offshore
proportions increase for these players, growth would look better
• As offshore proportions increase, these companies would show consistent margin
increases vs anticipated margin declines at Tier-1 IT progressively.
• Significant valuation discounts to Tier-1 IT names
We believe there could be a case for this preference to start shifting towards the more
reasonably valued India’s Tier-1 IT players as:
• Valuation discounts of MNCs vs the Indian Tier-1 IT players are inline with historical
averages and these discount could widen if revenue growth of MNC’s shows greater
volatility compared with Indian IT.
• Current economic conditions could create similar push factors like during the last
downturn, when MNCs showed sharper declines in revenue growth. This is on account
of: 1) accelerating cannibalization of onsite revenues as clients look to cut costs; 2) the
business cycle of consulting is one that usually gets affected first because of downturns
and consulting exposure of MNC players such as IBM and Accenture is higher
compared to India’s Tier-1 IT companies, which are more outsourcing focused.
3QFY12F preview
In our report “More pain or scope to gain”, September 2011, we had cautioned that
Indian IT companies would start to warn about demand deterioration from 3QFY12F and
that revenues would start to feel the impact of the slowdown from 4QFY12F. Indeed, this
has already started to happen, with cautious commentary from: 1) Infosys, which warned
about delays in decision-making and deterioration from the previous quarter; and 2) Tech
Mahindra and HCL Tech, which announced that the demand for discretionary has dried
up. In our opinion, 3QFY12F results will likely reveal moderating revenues, due to: 1)
clients conserving cash ahead of the year-end closing, especially for discretionary
projects; 2) seasonal weakness on account of lower billing days and shutdowns; and 3)
adverse impact on revenue growth of Tier-1 IT companies from cross currency
movements. We expect Infosys and TCS to give different comments but to post largely
similar revenue growth.
Results expectations
• We expect the Indian Tier-1 IT companies to post USD revenue growth of between
2.5% and 3.5% q-q in 3QFY12F with Infosys’ at the lower end of its guidance (3.2-5.4%
q-q) and TCS posting similar revenue growth as Infosys. We expect Cognizant to be
ahead of guidance at 4.7% q-q (vs guidance of 3.7%)
• Higher benefits would be seen at Infosys and TCS on margins due to rupee
depreciation. Cognizant is unlikely to see material rupee depreciation-related margin
positives given its higher hedging. We expect EBITDA margin improvements of
between 70-250bps across the Tier-1 IT companies (except for Cognizant), with the
lowest benefits at HCL Tech and highest at Infosys.
• Below the operating line, we believe impacts are likely to be divergent based on
hedging levels, with Infosys being the least affected by forex losses among the Tier-1
IT names, while TCS, Wipro and HCL Tech would get hurt more given their higher
hedging levels.
Key things to watch out for
• Cognizant’s FY12F revenue growth guidance would, in our view, offer the first peek into
the demand for IT services in calendar year 2012. We expect Cognizant to guide for at
least 21% growth - within the 18-23% range indicated by the company in its 8-K filing
for 50-100% vesting of its senior management’s restricted stock options (RSU).
• Infosys’ FY12F revenue growth guidance may be revised down marginally, in our view,
as its 3Q revenues might be closer to the lower end of its guidance, making it difficult to
achieve the higher-end of its revenue growth guidance of 17-19%. The likely change in
guidance for FY12F, in our view, would be driven by headwinds such as decisionmaking
delays, clients’ holding back on budgets and adverse cross currency impacts.
• At Wipro, we believe its next quarter revenue growth guidance needs to be closely
monitored, especially after its above-expectation guidance for 3Q. This should indicate
to us whether Wipro is able to sustain its revenue growth recovery. Lower-than-3% q-q
growth guidance (for 4QFY12F) would be taken negatively, in our view.
• HCL Tech’s deal announcements, amid expectations of a strong deal-signing quarter,
will be another key event to watch out for, in our view.
Result plays
• Despite divergent commentary, we expect Infosys and TCS to show similar revenue
growths in 3QFY12F - similar to the previous quarter. Hence, we would recommend to
Buy Infosys, where the Street’s expectations are low and earnings growth would likely
be higher than TCS, on account of lower forex losses.
• Wipro is one stock that we believe the risks of disappointment are highest among the
Indian IT companies, as expectations of a revenue growth recovery have been built
and failure to materialise is likely to lead to a negative stock price reaction, especially
given that the stock has outperformed the Nifty by 22% over the past 3 months.
• Among Tier-2 IT names, we are positively inclined towards iGATE, which remains our
top Tier-2 pick in the sector. We expect it to see positive progress on closing the gap
with its stated EBITDA margin guidance of 25% by June 2013.
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