Expert Speak

26 November 2013
Sector: Technology
Investors are advised to refer through disclosures made at the end of the Research Report.
1
Ashish Chopra (Ashish.Chopra@MotilalOswal.com); +91 22 3982 5424
Siddharth Vora (Siddharth.Vora@MotilalOswal.com); +91 22 3982 5585
Healthy jump in demand; captives, MNCs not yet a threat
Service-only mindset of Indian IT restrictive
Demand environment - US, Europe, Far East and emerging economies: Improvement
in demand is well noted in the US. What is significant is the jump in demand in
Europe, driven by Germany and France. Emerging markets - including Middle East,
China, India, Turkey and Indonesia - have huge government spending. Not many
barring TCS and Wipro have focused on this space.
Indian players may fail to tap SMAC opportunity by remaining "service only" players:
Indian service companies should be laying down highways rather than managing
toll booths. In SMAC segments, global giants are creating the infrastructure and
Indian companies get servicing or maintenance contracts.
Tier-II - differentiation imperative, as risk comes from vendor consolidation:
Tier-II companies serving same clients as tier-I are faced with a structural challenge.
Risk of vendor consolidation will always loom. Tier-II companies have lost most
from MNCs setting up delivery centers in India. Mindtree, Persistent and KPIT are
relatively differentiated and have carved their niches.
Captives, MNCs not yet a threat: Captives and MNCs are not yet a threat to the
domestic model, as they remain more expensive, and also, supplier capabilities
limit outsourcing in IP-sensitive areas.
Immigration Bill remains a challenge: Canada, which has come out very strongly on
the offshore service providers, is an example of impending risk. There is a lot of protectionism playing out in
these geographies.
Mr Milan Sheth
Mr Milan Sheth currently
leads the Technology
Practice at Ernst & Young.
His experience includes
commericalizing new ideas,
identifying white spaces in
the B2B segment for clients,
alliance and partnership
advisory, designing
operating models for
companies and
performance management
framework for large
enterprises in the
Technology/Telecom/
Convergence space.
Our view: We remain confident of the improving growth trajectory for IT Services, with demand in Europe
compounding to improving macro in the US. Deal signings in last couple of quarters lend healthy visibility to the
same. We prefer INFO among the top tier, followed by WPRO. Our other top picks in the sector are TECHM and
PSYS.
Comparative valuation
Company TP Upside EPS (INR) P/E (x) RoE (%) FY13-15 CAGR
(INR) (%) FY13A FY14E FY15E FY13A FY14E FY15E FY13A FY14E FY15E USD Rev EPS
TCS 2,180 9 71.2 95.0 108.9 28.0 21.0 18.3 37.8 40.3 36.5 16.3 23.6
I nfosys 3,960 19 164.9 183.2 219.7 20.1 18.1 15.1 25.7 24.1 26.4 12.5 15.4
Wipro 570 20 25.0 31.5 35.4 19.0 15.1 13.4 21.6 25.3 24.2 9.1 19.1
HCL Tech 1,275 20 57.0 80.0 91.0 18.6 13.2 11.6 32.2 38.5 33.7 15.0 26.3
Cognizant 3.4 4.0 4.8 26.9 22.9 19.3 23.9 22.8 21.8 19.5 18.2
Tech Mah. 1,900 11 93.0 125.0 149.5 18.5 13.7 11.5 32.6 34.7 32.1 15.4 26.8
Mindtree 1,330 (4) 81.7 120.1 132.7 16.9 11.5 10.4 25.8 34.0 29.5 15.4 27.4
KPIT Tech. 150 6 10.6 14.8 16.6 13.5 9.6 8.6 22.7 25.0 24.6 14.1 25.3
Persistent 900 3 46.9 61.3 74.9 18.6 14.2 11.6 20.2 22.4 23.2 17.8 26.4
Hexaware 138 17 10.9 13.4 15.3 10.8 8.8 7.7 30.1 30.4 28.5 9.6 18.5
NIIT Tech 311 (3) 35.5 41.4 44.4 9.1 7.8 7.3 21.3 20.7 18.8 10.2 11.8
Mphasi s 355.0 (10) 37.5 35.2 37.4 10.5 11.1 10.5 23.1 19.1 16.0 6.5 (0.2)
Source: MOSL
Expert Speak
26 November 2013 2
Demand environment - US, Europe, Far East and emerging economies
Improvement in demand is well noted in the US. The upturn is quite visible in the
last two quarters in terms of the number of deals signed as well as the number of
conversations.
Sustained growth in US geography in last two quarters expected to continue, ex-furloughs
Source: Company, MOSL
What is significant is the jump in demand in Europe. All the Indian IT companies
are focusing on France and Germany. TCS and Infosys have strong on ground
presence in Germany. France has been traditionally a conservative market even
for US players. It is dominated by local players like Cap Gemini and Atos Origin.
However, French MNCs are now much more open and are talking to Indian service
providers than local French companies.
Growth in Europe has been sparodic and inorganic in the past, outlook is strong
We see significant jump
in demand, particularly in
Europe
, ,
,,
Source: Company, MOSL
Emerging markets - including Middle East, China, India, Turkey and Indonesia -
have huge government spending. Not many barring TCS and Wipro have focused
on this space. These remain typically large value but low margin deals.
Indian players may fail to tap SMAC opportunity by remaining "service only"
players
The most fundamental problem in the Indian IT business model is that despite
opportunities in cloud, mobility, analytics, Indian IT companies have refrained
from building solutions/platforms, and their response is to be support-ready for
any product that is brought on the table. Indian service companies should be
Expert Speak
26 November 2013 3
laying down highways rather than managing toll booths. MNC giants have created
the infrastructure (for cloud) and Indian companies get servicing or maintenance
contracts.
Indian companies have not bought/built any significant product, and hence, have
no ownership of the products. The MNC space is plush with examples of companies
that transformed from what was thought to be their DNA. SAP, for example, moved
from a "products company" to a "solutions company". Dell too moved from
hardware to services. There is no Indian company wanting to become anything
but a Services company.
Tier-II - differentiation imperative, as risk comes from vendor consolidation
Tier-II companies serving same clients as tier-I are faced with a structural challenge.
Risk of vendor consolidation will always loom, as the contracts are up for
renegotiation every 3-4 years. There is opportunity of collaboration with large
Indian IT players, if they build a product or a platform, and work as sub-contractors.
But that is a lower margin business.
Mindtree, Persistent and KPIT are relatively differentiated and have carved their
niches. There clearly is a challenge for companies within tier-II whose offerings
are very similar to their larger counterparts. The alternative opportunity for tier-
II is forging strong relationships with clients that are tier-II or smaller companies.
Different strategies across the top-tier
Some companies have been mass players, with no aspiration of being perceived
as consulting or transformation partners. They are more than happy to provide
effective people at reasonable rates.
There have been prominent examples of other players striving to be value-led
players. However, it is necessary to back this by building those teams and give up
on commoditized volumes to change perceptions. Customers do not equate the
aspirations of companies in India to those of IBM and Accenture. Clients perceive
Indian counterparts as services players, and while they may get shortlisted for
transformational/consulting engagements, they do not end up getting the
business.
Captives, MNCs not yet a threat
Despite significant base in India, MNCs have a lot more overheads and are still a
lot more expensive and less price effective than Indian IT companies. Customers
are either seeking solutions or help in transformation or simply efforts/tasks. As
far as tasks are concerned, Indian companies are absolutely bang on and beat
global companies easily. However, in complex domain areas, barring one or two
Indian companies, others miss out. In transformational opportunities, Indians
probably win two out of 10 deals v/s none out of 10 deals five years ago.
As far as captives are concerned, in terms of IP-sensitive higher-end work, R&D
centers will continue to be set up in India. This will also be a case where skill-set
gap is being adequately met by the country. Commodity/non-sensitive work is
done by third parties. INR depreciation does make India more attractive but that
was never the only factor for setting up more captives.
Indian service companies
should be laying down
highways rather than
managing toll booths
, ,
,,
Companies having
aspiration of being a
consulting player need to
back themselves and be
ready to give up large
value/volume orders
coming their way
, ,
,,
Expert Speak
26 November 2013 4
Immigration Bill remains a challenge
The Immigration Bill is a genuine challenge for the industry. The number of on-
contract employers hired by Indian providers has shot up by 300-400% in some
companies, as they cannot get requisite immigration clearances for the employees
based in India.
Canada, which has come out very strongly on the offshore service providers, is an
example. These are not great signs and there is a lot of protectionism playing in
these geographies.
Pricing and margins: Pricing not an intermittent threat; margins to be defined
by choice of business and ensuing growth
Currency fluctuations have been tracked by most organizations very closely.
However, some of them are so cyclical that customers or services companies do
not always take it as a base for negotiations. Large contracts typically have built in
buffers, beyond which gains and losses get shared.
Like-to-Like pricing environment is stable in recent quarters
Source: Company, MOSL
In IMS, the key growth driver for the industry, margins in offshore-onshore model
are 10-14%. In pure offshore IMS, the margins can be in high teens but possibility
to scale up is limited. You need to have onsite presence of people. Overall margins
will be a function of the business mix chosen by the players. Moving up the value
chain may require investments that will bridge the margin gap with MNCs.
Reinvesting margin benefits from currency to drive growth
Source: Company, MOSL
Expert Speak
26 November 2013 5
Valuation and view
Prefer INFO, WPRO, TECHM, PSYS
INFO our top pick in tier-I, prefer TECHM and PSYS
2QFY14 was the third quarter in the last four when INFO surprised positively on revenue
growth. While the guidance for 2HFY14 is muted, driven by multiple factors, we see
the management's stance as conservative, with cautious outlook on the US
government shutdown and some softness in the Retail vertical. INFO has inched up
its IT Services and Consulting utilization including trainees by ~900bp in six quarters,
but this has been offset by higher costs elsewhere. However, with a continuously
reassuring growth outlook, we expect other levers on margins to kick in gradually,
and remain sanguine on the prospects of improving financial metrics, going forward.
INFO remains our preferred pick in top-tier IT v/s TCS, which continues to enjoy
significant valuation premium.
In line with our expectation, WPRO's deal momentum drove sanguine revenue growth
outlook for the second consecutive quarter, despite 3Q being a seasonally weak
quarter for the industry. Fruition of WPRO's investments had remained elusive, lacking
support from the macro environment, but early signs of the same were visible in
2QFY14 performance and continued deal closures. Maintain Buy.
Continued closure of orders keep prospects of revenue growth at HCLT sanguine. A
sustained revival in discretionary spending will potentially compound to the revenue
traction for the company. HCLT's margins are the highest in over a decade, and while
the margins may cool off going forward, it is braced for the best growth in earnings
across the top-tier. We see limited undue pressures to growth and margins in the
near-to-medium term, and see HCLT positioned well to benefit from improving trends
in demand environment. Maintain Buy. In lower Tier we prefer TECHM and PSYS.
Comparative valuation
Company TP Upside EPS (INR) P/E (x) RoE (%) FY13-15 CAGR
(INR) (%) FY13A FY14E FY15E FY13A FY14E FY15E FY13A FY14E FY15E USD Rev EPS
TCS 2,180 9 71.2 95.0 108.9 28.0 21.0 18.3 37.8 40.3 36.5 16.3 23.6
I nfosys 3,960 19 164.9 183.2 219.7 20.1 18.1 15.1 25.7 24.1 26.4 12.5 15.4
Wipro 570 20 25.0 31.5 35.4 19.0 15.1 13.4 21.6 25.3 24.2 9.1 19.1
HCL Tech 1,275 20 57.0 80.0 91.0 18.6 13.2 11.6 32.2 38.5 33.7 15.0 26.3
Cognizant 3.4 4.0 4.8 26.9 22.9 19.3 23.9 22.8 21.8 19.5 18.2
Tech Mah. 1,900 11 93.0 125.0 149.5 18.5 13.7 11.5 32.6 34.7 32.1 15.4 26.8
Mindtree 1,330 (4) 81.7 120.1 132.7 16.9 11.5 10.4 25.8 34.0 29.5 15.4 27.4
KPIT Tech. 150 6 10.6 14.8 16.6 13.5 9.6 8.6 22.7 25.0 24.6 14.1 25.3
Persistent 900 3 46.9 61.3 74.9 18.6 14.2 11.6 20.2 22.4 23.2 17.8 26.4
Hexaware 138 17 10.9 13.4 15.3 10.8 8.8 7.7 30.1 30.4 28.5 9.6 18.5
NIIT Tech 311 (3) 35.5 41.4 44.4 9.1 7.8 7.3 21.3 20.7 18.8 10.2 11.8
Mphasi s 355.0 (10) 37.5 35.2 37.4 10.5 11.1 10.5 23.1 19.1 16.0 6.5 (0.2)
Source: MOSL
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