India Offshoring Quarterly Snapshot

Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent report to clients on Indian offshorers:

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Macro Observations & Company Developments

Deteriorating global news flow has finally caught up with the offshoring sector – leading to more instances of project deferrals, pricing pressure and even a planned hiring freeze at Infosys (INFY). We recently reduced our EPS estimates across-the-board to factor disruption in IT spending decisions amid the ongoing global financial crisis and economic downturn. Our models assume subdued or no QoQ revenue growth in the next three quarters. Still, we can point to essentially flat EPS in 2009E and inexpensive valuations – averaging 11x forward EPS vs. 13x for the S&P-500.

Reassuring attributes include above-average visibility (multi-year agreements contribute ~50% of revenue); strong balance sheets (aggregate net cash at the four U.S. listed majors = $3.6 billion); robust trailing CFFO amounting to $2.9 billion (19% margin) vs. capex of $1.1 billion; and a promising intermediate-term outlook that should support 20% top-line growth in 2010 and beyond, i.e., upon the return of a more normal environment, we anticipate substantial demand for M&A integration, risk management, regulatory compliance and various cost reduction initiatives. We also observe a diligent focus on optimizing internal operations and reigning in compensation expectations.

As for the Satyam (SAY) debacle, we advocate that management (9% ownership) renew its commitment to the IT business and launch a $400-500 million buyback to enhance future EPS power – or risk falling into the hands of an unwelcome suitor. The move by TCS to acquire a captive Citigroup BPO unit (for 1.8x 2008E revenue) was better received by investors.

Favorite Stocks

On the basis of projected upside, Satyam (+85% in 12 months) ranks as our top bellwether pick at this time. Based on revisions to our calendar 2009 GAAP EPS estimates, Cognizant (CTSH) (-11%) posted the best quarterly results.

• Nasdaq vs. Sensex: the BSE-30 index has corrected 52% from its January high – and is down 47% YoY compared with a 40% Nasdaq drop.
• Valuation: function of global risk appetite and overall earnings visibility; forward P/E of 10x compares with 7% est. EPS growth in FY08-10.
• Foreign and domestic institutional activity: international interest in the Indian market has reversed after an extended spell.
• Sector winners and losers: IT not in favor; aggregate market capitalization of four IT bellwethers = 11% of current BSE-30 total.
• ADR premium (or local discount): explained by U.S. investor demand, peer valuations, market risk and absence of an arbitrage opportunity.
• Currency exposure: depending on a company’s cost structure, a 1% currency swing can impact operating margin by 20-50 bps.

Macro Observations

• Economic growth: long-term drivers are policy reforms & demographics; soft-landing scenario anticipates moderation to 5-6% YoY growth.
• BSE market capitalization: $897B at end-September or 0.8x forward GDP.
• Inflation: 6.8% as of early-December and likely to move lower through mid-2009.
• Interest rates: monetary policy bias has shifted unequivocally toward easing.
• Dollar purchases by RBI: $39B (net) during the preceding four quarters.
• Forex reserves: $250B as of mid-December.

IT Sector Trends

• Growth: Cognizant owns best record (7.1% LTM QCGR).
• Profitability: wide range explained by management, scale and reinvestment philosophy; productivity levers include employee- and offshore-mix.
• Attrition: indicates easing wage inflation, which has translated into ~300 bps of margin pressure annually.
• Offshore price realizations: a fading margin lever – drivers are bargaining power, ramp-up of newer clients and business-mix.
• Outlook: $60B NASSCOM target implies 22% compound growth in FY08-10 and 20% market penetration; FY08 GDP contribution = 5.5%.
• Prevailing sentiment: conveys concern over a global economic slowdown – and longer-term shortage of employable graduates.

Internet & Wireless Sector Statistics

Telecom Service sector revenue amounted to $32 billion in fiscal 2008.

• Wireline Internet subscribers: 11.7M, up 26% YoY. Incl. 81% YoY jump in broadband to 38% of the total, excl. mobile access by 76.0M subs.
• Internet Service Providers: BSNL has gained significant market share – primarily at the expense of Sify and MTNL.
• Wireless subscribers: 286.9M = 55% YoY growth driven by low tariffs and teledensity (25.0%).
• Wireless operators: Bharti has posted the greatest LTM market share gain – and BSNL the largest drop.
• GSM segment: Bharti remains market share leader while Vodafone (VOD) has acquired momentum.

Offshoring Specialists: Relative Price Performance (LTM)

Disclosure: The author of this report has a long position in the common stock of Cognizant (CTSH) and Patni (PTI).

Comments

[Glen Bradford:]

I like CTSH, so you're doing something right. I would like to see charts that are a little more applicable. I can't get the big picture from 5 data points or from ones I can't really see. There were some good ideas tossed around.

Do you have any opinion on NII Holdings (NIHD)?

2008 Dec 23 04:08 PM