Quarterly Preview : Indian Technology Stocks Looks Attractive

Big brands on summer sale. We believe the likely reduction in Infosys‘ FY2008- rupee-based EPS guidance on account of the rupee appreciation is factored in the stock price. Core business drivers including volume, pricing and margins (ex currency) remain intact and would aptly reflect in Jun’ 07 quarter performance. The recent correction in stock prices offers a good entry point. We maintain our attractive view of the sector with Wipro and Infosys as our top picks.

Valuations—the worst is factored in : We believe the risk-reward ratio has turned favorable for most Indian IT stocks under our coverage after the recent run down in stock prices. The IT sector has underperformed the Sensex by 13.5% and 15% over the past three and six months, respectively. We remain positive on the sector noting that the core business metrics (ex-currency) remain buoyant and that the negatives are already in the price.

Infosys will likely reduce FY2008 Re EPS guidance, maintain US$ EPS guidance : We believe Infosys would be able to protect its FY2008 US$ EPS guidance of 1.86-1.89 by raising US$ revenue growth guidance to 32-34% (from 28-30%). However, protection of FY2008 EPS growth guidance of 20-22% is unlikely; we expect this number to be revised
downwards to 14-16%, implying an EPS of Rs76-78. We expect Satyam to maintain its US $ EPS guidance and marginally reduce its Re EPS guidance by 1.7% to Rs25.3 from Rs25.7.

Jun ’07 quarter—modest revenue growth, OPM decline : We expect another quarter of strong revenue growth for Tier 1 companies led by volume growth (5-8%) and pricing improvements. We expect Satyam and HCLT to lead the sector in revenue growth (8-9% US $ terms qoq). Operating margin will likely get impacted by wage hikes, visa costs and rupee appreciation. We expect OPM decline of 250-350 bps for companies that effect wage hikes in the Jun ’07 quarter and 50-150 bps for others. Infosys and TCS would be impacted the most as they have effected wage hikes in this quarter.

Hedging critical for meeting FY2008 expectations : Hedging is critical to meet FY2008 EPS expectations and 1QFY08 EPS guidance. Companies like TCS, Satyam and HCLT with hedges exceeding net monetary assets stand to gain. We expect Satyam to meet its 1QFY08 Re-EPS guidance and Infosys to fall short.

Valuations—the worst is factored in We believe the recent decline in IT stocks provides good entry points into some toptier names. Frontline IT stocks (except HCLT) have corrected between 13% and 19% over the past three months, primarily due to the rupee’s appreciation against major currencies (US$, GBP, and Euro). We believe most of the negatives have been factored into prices. We remain confident on the core business and expect 15%+ returns from tier-I stocks in the next 12 months. Wipro and Infosys are our top picks.

A time to buy We believe the risk-reward ratio has turned favorable for most frontline Indian IT stocks. The tier-I companies have underperformed the Sensex by 13-19% and 15-21% over the past three and six months, respectively, and are currently trading at the lower end of their 1-year forward P/E bands (see Exhibit 1). We believe the street has factored in the negative concerns concerning rupee appreciation while overlooking the positives—strong underlying demand and margin protection levers. Despite the appreciating rupee and likely tax rate increase in FY2010, we expect an earnings CAGR of 16-20% for the tier-I companies. We believe that the stocks provide reasonable upsides even assuming a Re/US$ rate of 40 for FY2008-10. We discuss our distress case valuations of the frontline stocks below. We prefer Infosys and Wipro over other frontline stocks given (a) better growth profile vis-à-vis peers, (b) more operating margin levers like low utilization rates, onsite-offshore mix, performance of subsidiaries/ acquisitions etc, and (c) faster SEZ ramp-up than peers.

Wipro and Infosys provide 7-25% upside even in distress-case scenarios Exhibit 2 presents our distressed case DCF valuation for the tier-I Indian IT stocks. Our current EPS estimates factor in a Re/US$ rate of 42, 42, and 41 for FY2008, FY2009, and FY2010, respectively. Assuming a scenario rate of 41 for FY2008 and FY2009, our EPS estimates decline for FY2008 and FY2009 stands at 2-5% for various companies. The target prices in this scenario stand reduced by 2.3-4.3% for various companies. We note that we do not factor in any operational efficiencies or pricing improvements in these scenarios. Wipro and Infosys provide an upside of 17% and 7% over the current levels even at a Re/US$ scenario rate of 40 for FY2008-FY2010.

Guidance—maintaining EPS guidance likely to be tough We expect Infosys to reduce FY2008 Re EPS guidance by 5-7% to Rs76-78. The entire downward revision will likely be on account of rupee appreciation. However, we expect the company to protect its US $ EPS guidance. Satyam may be better placed than Infosys given its better hedging relative to net monetary assets. We expect Satyam to marginally reduce its Re EPS guidance by 1.7% to Rs25.3 from Rs25.7.

Maintaining Re EPS guidance for FY2007 unlikely at the current Re/US$ rate for Infosys depicts our estimates of revenue growth required by Infosys under Re/US$ scenarios of 41 and 40.7 to maintain EPS guidance. Infosys would need to revise its US $ revenue growth guidance upwards by 11% (to 41%) to meet its Re EPS guidance at Re/US$ rate of 40.7. Infosys based its initial FY2008 guidance on Re/US$ rate of 43.1; likely revised guidance at 40.7 means an appreciation of 5.6% and incremental OPM pressure of 220 bps. We believe that the company would be able to offset 160 bps of pressure on the back of (a) lower variable compensation benefiting the company by 70-80 bps and (b) likely higher pricing from 4QFY07 levels, which was not factored in the guidance by the company. However, 60 bps still remain unaddressed, which in our view will impact the guidance. We expect the eventual Re EPS guidance to be revised down to Rs76-78 based on revenue growth assumption of 32-34% in US$ terms for FY2008

US$ EPS guidance may be protected We believe that Infosys may be able to protect the upper end of its FY2008 EPS guidance of US$1.89. Based on our calculations, the company needs to increase revenue guidance to 34% at the upper end of the band assuming that the guidance for the remainder of the year is based on Re/US$ rate of Rs40.7 (see Exhibit 5). Exhibit 6 details the revision in US$ revenue growth guidance by Infosys in after past June quarter results.

Operating margin reconciliation—levers available at the disposal pressures including visa costs, wage revisions and rupee appreciation. Infosys has total levers of ~900 bps, of which it can pull 575 bps in FY2008, in our view. Assuming that FY2008 EPS guidance is based on 40.7, we forecast OPM decline of 130-180 bps in FY2008.

Satyam—better placed than peers We expect Satyam to maintain its US$ EPS guidance and marginally reduce its Re EPS guidance by 1.7% to Rs25.3 from Rs25.7. Satyam gets an additional benefit of Rs400 mn of likely profits from forward hedges in excess of net monetary assets. We believe the company will likely raise its FY2008 US$ revenue growth guidance by 4% to a growth of 32-34%. Exhibit 8 details our likely EPS assumptions scenario for FY2008 and Exhibit 9 details the revision in US$ revenue growth guidance by Satyam after past June quarter results.

Key considerations for Jun ’07 quarter We believe the sharp rupee appreciation during the quarter may lead to Indian IT companies missing their revenue and EPS guidance for the quarter in Re terms despite strong qoq revenue growth in US$ terms. We expect 4-14% and 2-11% US$ revenue growth for tier-I and tier-II companies. We forecast a qoq OPM decline of 50-260 bps for the tier-I names in our coverage universe as a result of rupee appreciation, wage revisions, and higher visa costs. Net income impact would be mitigated to some extent by gains on forex hedges. Expect revenue guidance outperformance in US$ terms, shortfall in Re terms Frontline IT companies have proferred qoq revenue growth guidance of 3-5.5% (US$ terms) for the Jun ’07 quarter (see Exhibit 10). We expect most of the companies to outperform their US $ based guidance by 0.9-3.2% (see Exhibit 11). However, the rupee’s appreciation against the US $, GBP, and Euro may lead to the companies missing their Re-based revenue and EPS guidance by 1-3%. Among the frontline companies, we expect Satyam and HCLT to lead the qoq revenue growth rates with 8-9% qoq revenue growth rate (US$-terms).

OPM decline likely to be severe India Technology 3QFY07 4QFY07 1QFY08E We forecast qoq OPM decline for all the companies under our coverage universe. The extent of the operating margin decline is contingent on (a) wage increase cycle: Infosys effects wage increases for all the employees in the June quarter. TCS also effects wage increases for all employees in the June quarter but leaves promotions to the subsequent quarter. Satyam has a wage increase cycle in the September quarter; and (b) dependency on H1B visas: An H1B visa costs US$3,000-3,500 per application to process. Infosys relies almost exclusively on H1B visas; Satyam and Wipro has high exposure to H1Bs. TCS has the least dependence. Overall, we expect a 2.6% OPM decline for Infosys, 2.6% for TCS, 1.3% for Wipro (Global IT) and 0.8 % for Satyam.

Forex hedges may partly mitigate impact of rupee appreciation at the net income level Net income impact would be mitigated to some extent by gains on forex hedges. We expect HCL Tech (Rs1.2 bn) and TCS (Rs800 mn) to report the highest forex gains among the tier-I names given their large hedging positions at end-Mar 2007

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