Significant earnings deceleration ahead. Rupee depreciation has driven stable stock performance for the Indian IT names despite material deterioration in yoy revenue growth trajectory. This benefit may not last for long as the Rupee depreciation kicker to earnings will likely start to wear off from Dec 2012 quarter with companies potentially reporting a deceleration in earnings growth to even a decline on yoy comparison. Slowdown and increased competitive intensity drive our Cautious view on Tier-1 IT.
Strong Rupee EPS growth has masked deterioration in core business…
Divergence between US$ revenue and Re earnings growth (yoy) started in Dec 2011, a quarter where Rupee depreciation was noticeable and led to EBTIDA margin improvement. Acceleration in yoy earnings growth despite deceleration in revenue growth (Exhibits 1-4) has continued for the past few quarters, aided by Rupee’s sustained weakness. Sharp Re depreciation helped (1) absorption of cost inflation and pricing pressure, (2) robust translation-driven (US$ to Rupee) earnings growth and (3) prevent a material decline in stock prices.
...however even the Re earnings growth trajectory will likely decelerate starting Dec 2012
US$ revenue growth will moderate to a modest 3.5-13% for the Dec 2012 quarter for various Tier-1 companies. Benefits of Rupee depreciation will level off with Dec 2012E rate of Rs52.5, unlikely to be materially different from Rs51.5 in Dec 2011 quarter. For the Dec 2012 quarter, we expect companies to report a decline in earnings (Infosys) or at best, modest growth (Wipro, TCS). We note that Tier-1 IT companies rarely reported yoy Re earnings decline; never since listing for TCS, only twice for Infosys in March and June 2010 and never for Wipro since FY2003.
‘Free of Re gain’ numbers from Dec 2012 will start showing the underlying earnings stress
Challenges (revenue growth as well as ex-Rupee margin) for Indian IT companies will start showing up in reported earnings from Dec 2012 quarter. We highlight a few
· Slowdown in key verticals; failure to open new growth avenues. Slowdown in two key verticals (BFSI/Telecom) has impacted sector growth materially. Collective failure of the industry in expanding addressable market beyond the traditionally strong areas does not help either.
· Fragmentation instead of consolidation. Consolidation aided better-than-industry growth for the Tier-1 IT in the past. However, competition has increased materially over the past few quarters. HCLT has bought back relevance, Accenture and IBM are making an increasing dent in the offshore services market, CTSH is larger and hungrier and even Satyam/TM combine are making their presence felt in select verticals. Effectively there are 7-8 Tier-1 players jostling for a share of the shrinking incremental revenue pie. Pricing/margins suffer as a result in a slow growth year (as is the case with FY2013E).
· Increasing cost pressures. Visa constraints, rebadging-led adverse impact on employee pyramid and increasing complexity of services (though not rewarded with favorable pricing) have driven up cost structure and taken away benefits of Rupee depreciation. We do not expect any let-up in the industry-wide cost pressures.
· Street’s Re-benefit-reinvestment thesis on margins will likely start getting challenged once companies report a yoy decline in margins from Dec 2012 quarter. Reinvestments, in common areas across players, run the risk of becoming part of ‘recurring’ cost structure.
Strong Rupee EPS growth has masked deterioration in core business…
Divergence between US$ revenue and Re earnings growth (yoy) started in Dec 2011, a quarter where Rupee depreciation was noticeable and led to EBTIDA margin improvement. Acceleration in yoy earnings growth despite deceleration in revenue growth (Exhibits 1-4) has continued for the past few quarters, aided by Rupee’s sustained weakness. Sharp Re depreciation helped (1) absorption of cost inflation and pricing pressure, (2) robust translation-driven (US$ to Rupee) earnings growth and (3) prevent a material decline in stock prices.
...however even the Re earnings growth trajectory will likely decelerate starting Dec 2012
US$ revenue growth will moderate to a modest 3.5-13% for the Dec 2012 quarter for various Tier-1 companies. Benefits of Rupee depreciation will level off with Dec 2012E rate of Rs52.5, unlikely to be materially different from Rs51.5 in Dec 2011 quarter. For the Dec 2012 quarter, we expect companies to report a decline in earnings (Infosys) or at best, modest growth (Wipro, TCS). We note that Tier-1 IT companies rarely reported yoy Re earnings decline; never since listing for TCS, only twice for Infosys in March and June 2010 and never for Wipro since FY2003.
‘Free of Re gain’ numbers from Dec 2012 will start showing the underlying earnings stress
Challenges (revenue growth as well as ex-Rupee margin) for Indian IT companies will start showing up in reported earnings from Dec 2012 quarter. We highlight a few
· Slowdown in key verticals; failure to open new growth avenues. Slowdown in two key verticals (BFSI/Telecom) has impacted sector growth materially. Collective failure of the industry in expanding addressable market beyond the traditionally strong areas does not help either.
· Fragmentation instead of consolidation. Consolidation aided better-than-industry growth for the Tier-1 IT in the past. However, competition has increased materially over the past few quarters. HCLT has bought back relevance, Accenture and IBM are making an increasing dent in the offshore services market, CTSH is larger and hungrier and even Satyam/TM combine are making their presence felt in select verticals. Effectively there are 7-8 Tier-1 players jostling for a share of the shrinking incremental revenue pie. Pricing/margins suffer as a result in a slow growth year (as is the case with FY2013E).
· Increasing cost pressures. Visa constraints, rebadging-led adverse impact on employee pyramid and increasing complexity of services (though not rewarded with favorable pricing) have driven up cost structure and taken away benefits of Rupee depreciation. We do not expect any let-up in the industry-wide cost pressures.
· Street’s Re-benefit-reinvestment thesis on margins will likely start getting challenged once companies report a yoy decline in margins from Dec 2012 quarter. Reinvestments, in common areas across players, run the risk of becoming part of ‘recurring’ cost structure.
