India IT Services - Battling tough times - Anand Rathi

In the past 12 months, the CNX-IT Index (-9.67%) has underperformed the Nifty (+26.4%) by wide margin of 36.1%. We anticipate this underperformance to continue for the next two quarters, especially in light of continued cost pressure and absence of positive management commentary regarding demand environment. However, high ROEs, along with compelling valuations, provide comfort at current levels.

- Growth rates facing discernible slowdown. The four large cap IT companies together are expected to record 11.6% CAGR during FY12-14 against 15% in FY09-12 (down from the over 33% in FY02-09.) Together with falling margins (32% in FY02 to 25% in FY12), this has proved to be a great dampener for the sector.

- Likely rupee appreciation to add to woes. The rupee's sharp depreciation against the US dollar and other major currencies had provided some semblance of relief to Indian IT companies in the past five quarters. We, however, expect the rupee to appreciate against the US dollar in the next 12 months, putting the squeeze on Indian IT firms. The concern is aggravated by the fact that hedging policies of IT majors are not used to sudden currency fluctuations (as seen in past four months).

- Time for multiple contractions. Large caps are trading at 12-60% discount to their long-run average PE multiples. This could continue, with average multiples reducing from 18-22 to 12-15. As predictability of growth slides down, it will take a toll on premium valuations.

- Top pick. We prefer HCL Tech for its low valuation (12x FY14e) and high growth in revenue (FY12-15e CAGR - 12.5%) and earnings (FY12-15e CAGR - 17.6%), driven by growth in FPP-based contracts and IMS/BPO segments (31% of revenue).

Source : Equity Bulls

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