IT SECTOR : EQUITY RESEARCH REPORT

INDUSTRY ANALYSIS:
IT Sector shines again: Large Indian IT companies are demonstrating commendable scale
up with US$ revenue growth for 1HFY14 being 15% yoy compared with 11% in 1HFY13.
Companies were able to maintain margins (ex currency) as utilization started improving after
hitting lows towards the end of FY12, taking wage hikes and S&M investments in their
stride.
Currency (USD:INR rate), a key variable for competitiveness, remained favourable,
depreciating 40% since 1QFY12.Higher growth was on account of improved business
environment in the key US and European geographies, together contributing ~86% to the
revenues of large Indian IT companies. Also, the development of new SMAC1 technologies
and regulatory spends triggered a new tech spending curve in the sector with clients
committing more resources to the technology services/products. The previous tech spending
curve was triggered when ERP technology was implemented and later consolidated.
Indian IT companies have also improved their service/execution capabilities, as reflected in
their success in bagging large deals in recent years. TCS, for instance, has won 36 large deals
over the past 12 months.

The large deal market is expected to heat-up further with Everest group estimating IT deals
worth US$90-100bn to be up for renewal over April 2013October 2014. These deals are
largely spread across BFSI, manufacturing, and telecom verticals. In terms of service lines,
they will be spread across IMS and ADM, with Cloud replacing some part of traditional
spend in ADM. Amongst key geographies, Europe will play a critical role in the renewals,
and we expect growth momentum of Indian IT players in Europe to continue for a few more
quarters at least. Europe has grown at ~22% in 1HFY13 for large Indian IT vendors.


Revenue surge amplified by currency gains. Large Indian IT companies have seen
US$ growth accelerating to 15% yoy in 2QFY14 from 10% in 2QFY12. Management
commentary has also turned positive on demand environment/deal signings in the
US and Europe. Currency has largely stabilized in the range of ~`61-63/US$
resulting in higher rupee revenues.

Growth uneven; new service lines shine. BFSI and manufacturing verticals
reported higher growth rates at 16% and 18% respectively in 1HFY14. Amongst
geographies, Europe reported best ever 3QCY for outsourcing, while IMS and
enterprise & testing service lines led growth at 25% and 17% respectively.
Discretionary expense in technology services came back as companies started
adopting SMAC technologies.






Margins to be stable on constant currency. Growth acceleration will act as one
the biggest margin levers for companies as it improves utilization levels and flattens
the pyramid, offsetting margin pressures due to wage hikes in a muted pricing
environment. We expect TCS, Infosys, Wipro and HCLT to report 28%, 25%, 19%,
and 18% EBIT margins, respectively, over FY15-16.

Comparative analysis of valuations:














COMPANY ANALYSIS:
Infosys Limited: Buy
Infosys Limited, which booked $7.91 billion in total revenue during the last 12 months, has
maintained a steady and healthy sales growth record over the short and long term. This figure
represents a 56.76% increase from total revenue of $5.04 billion reported by the company for
the 12 months ended three years earlier. It also booked $2.05 billion in revenue last quarter,
13.85% higher than the $1.80 billion in the same quarter last year, extending the rate at which
it has been growing its business in recent years.

Assuming competent management of this top line growth, Infosys Limited's shareholders
should also expect steady, if maybe somewhat moderate, profit growth in the next few
quarters. It reported also that profit fell last quarter from the year earlier period, impacting
also long term profit growth.

Long term profit growth has been estimated based on the change in full year (12-month
trailing) net income from the comparable period three years before. Infosys Limited's Third
quarter net fell -12.05% to $381.51 million from the year earlier profit of $433.76 million
(excluding extraordinary items) , which contrasts with its growth in 12-month trailing profit
over a three year period. Also including last quarter's results, the company's profit grew to
$1.68 billion for the 12 months ended September 30, 2013, a 26.74% jump from full year
profit of $1.33 billion reported for the period ended three years earlier. During the last quarter
the company's ongoing margin contraction accelerated, with an average drop in EBITDA,
operating and net margins of -15.81% from the year ago period.

Valuation chart:



The company has no debt, which gives it plenty of room to find capital if necessary in light of
the recent downturn in its numbers. However, it is still very profitable and nothing currently
indicates it would need to take such a step. Infosys Limited's core operations, as measured by
the company's EBITDA, have generated $2.40 billion in earnings over the last twelve
months, a modest -9.39% decline from the $2.65 billion earned in the equivalent period
ended a year ago. EBITDA is used as a way of measuring core earnings since it includes
money earned in its operations such as interest expense, income taxes paid and depreciation
and amortization, both of which are non-cash charges.

Infosys Limited has a strong 12-month trailing profitability record based on solid returns on
shareholder equity, operating margins that exceed its peer group average and a remarkable
net profit margin. The $1.68 billion net profit earned by the company in the last four quarters
was equivalent to 21.27% of total sales. The Information Technology Services industry had
an average operating margin of 10.42% in the period. The company's operating margin of
23.66% exceeded that average by 116.71%. Based on its trailing 12-month earnings, Infosys
Limited return on equity of 24.37% is a very strong indicator of profitability and a positive
reflection on the company's management efficiency. However, it represents a decline from
the year earlier period's return on equity of 25.27%, possibly spelling a slowdown in the
company's business.








HCL : Buy

HCLs core IT services business has slowed significantly in the last 5-6 quarters. Analysts
dont see an imminent turnaround, as increased off shoring in the Applications and ERP
business and overall weaker market positioning limit upside potential. In future it can face
increasing competition from Indian service providers (SPs) like Wipro. Undoubtedly, the
IMS market is large (USD200bn-plus with less than 5% offshore penetration) and most
competition comes from global SPs such as IBM. HCLs IMS business may still grow at
20%-plus in the next 2-3 years; however, increased competition will likely restrict the upside
potential to overall revenue estimates and consequently impede the stocks re-rating.

The stock is trading at a 12.8x PE on FY15e EPS. However, this assumes a 350bp-plus
margin decline from the 1Q run-rate (FY15e EBIT margin of 20% vs. 23.8% in 1QFY14)
see Chart 3. Even if the company is able to preserve half of the expected decline, there could
be 7-10% upside potential to FY15e earnings. Therefore, analysts expect reasonably
plausible scenario of 21-22% EBIT margin for FY15e, the stock is trading at less than 12x,
which is in line with mid-cap peers and a steep discount to the rest of the large-cap peers
universe.








Valuation chart:







HCL has a head-start in the IMS business and competition will likely take time to replicate
its IMS solution/delivery capabilities, according to management. Low penetration and the
large size of the IMS market provide long-term growth visibility, added the CFO. The
annuity base characteristics of IMS deals add to the revenue and cost management
capabilities. On the IT services business, due to the changing paradigm of application
maintenance, led by app-consolidation and migration to the cloud, incremental growth will
likely remain modest. Growth in the past few quarters has been largely in offshore, which
adds to profitability but not top-line dollar growth.

The stock is trading at 14x 12-month forward earnings and a 12.8x PE on FY15e EPS. We
expect the current valuation to sustain and value the stock at a target multiple of 14x on 12-
month earnings, ending September 2015e, to arrive at target price of INR1,225





Wipro: Hold

Wipro, owing to its prolonged lower-than-peers growth rates, has been ceding ground to its
competitors on US$ revenues market share basis. However, a reversion to industry growth
rates is on cards as management indicated during 2QFY14 earnings that Wipro may return to
industry growth rates in FY15E.

Wipro has lost ~370bps of revenue market share during FY10-13. It continued to lag behind
peers in 1HFY14 during which it increased its revenues 5.4% yoy against an average growth
rate of 16.7% yoy for its peers. Management mentioned during the 2QFY14 earnings that the
company is expected to return to industry growth rates in FY15E.

Wipros strategy has been to win wallet share in the top 125 accounts of the company to
accelerate growth rates. The strategy has started yielding results with Wipro seeing an
improvement in deal win rates in 2QFY14. The company also saw some large deal closures
which should help it report better growth rates in 2HFY14.

Wipro is seeing strong demand in BFSI and manufacturing, but has observed certain gaps in
its offerings. The company is stepping up investments in the insurance sub-vertical to
accelerate growth in BFSI and is reducing its dependence on the Hi-Tech sub-vertical to
report better growth in the manufacturing vertical.



Valuation chart:




Wipro delivered 18.8% EBIT margins in 2QFY14 on back of a healthy 22.5% margin in IT
services business, up 252bpsQoQ.Analysts see further scope of improvement with gross and
net utilization running low at 66.1% and 74.3%, compared with TCS gross and net
utilization at 75% and 83.4%, respectively. This margin cushion should help the company
maintain its EBIT margins at 19% in FY14E, FY15E, and FY16E at the company level in a
stable currency environment despite investments in the high growth service lines.






TCS: Hold

TCS has exhibited superior execution capabilities consistently over the past few years and
has become a sector leader on both the fronts growth and profitability. On estimates, it has
gained market share amongst the large Indian IT companies in all the key verticals except
manufacturing, where its market share has remained stable. The story is similar on the service
lines and key geographies front, reflecting the broad-based success of the company over
the past two years.

TCS increased its revenue market share to 31.5% in 2QFY14 from 30.4% in 1QFY12,
ranking only after Cognizant in terms of revenue market share gains. During this period,
while Infosys and Wipro lost some ground on market share, HCLs share remained largely
stable. TCS wider reach in service offerings and superior processes were critical to this
financial performance and got reflected in increasing revenue per active client for the
company, which is now highest at ~US$3mn/ client/quarter, up from US$2.5mn in 2QFY12.

Analysts expect TCS to grow its revenues at 15% CAGR over FY13-16E, tad below TCS
current run rate of 16.5%, reflecting higher base effect and anticipating increase in
competitive intensity from its Indian peers. Companys expected growth rate also factors in
higher growth in manufacturing vertical in the forecasted period compared with that in BFSI
where TCS has experienced both higher growth and market share gains.

TCS EBIT margins are perhaps running above the normalized margins (TCS reported
2QFY14 margins at 30.2%) with management maintaining its comfort range of 26-28% over
the medium-to-long term. Also, there is little scope left in traditional levers with gross
utilization at 75%, assuming limited pricing power. For FY14, analysts expect EBIT margins
to remain high at 29.7% and then expect reversion to 28% in FY15/16.























Valuation chart:





Analysts expect that company will grow its US$ revenues at ~16% CAGR over FY13-16E,
touching US$18bn in sales in FY16E and will have a stable EBIT margin of ~28% over the
period, the stock is currently trading at 18.7x FY15E EPS, potentially limiting the upside for
investors. Recommend Hold.