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Excerpted from Gilford Securities analyst Ashish R. Thadhani's recent report to clients on Wipro (NYSE:WIT):

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Based on slow IT spending in a deepening global economic downturn – with significant exposure to the Financial Services and Technology verticals – we are adjusting our estimates as follows: fiscal 2009 EPADS to $0.51 on revenue of $5.548 billion (12% YoY growth) from $0.50 on $5.628 billion; and fiscal 2010 EPADS to $0.50 on revenue of $5.581 billion (1% YoY growth) from $0.55 on $6.195 billion. At this time, we are introducing a fiscal 2011 EPADS estimate of $0.50 – including a one-time jump in the tax-rate – on revenue of $6.123 billion (10% YoY growth). Our current model anticipates no sustained upturn in IT Services revenue until the March 2010 quarter. In this environment, even flat revenue and EPS in calendar 2009E should attest to the durability of a business model. We are lowering our target price from $9 to $7.50. In 12-months, this would correspond to 15x forward EPS – a modest premium to the current valuation (13x).

3Q09 EPADS of $0.13 on revenue of $1.346 billion beat our $0.12 estimate on revenue of $1.411 billion. Revenue was held back by currency volatility (-$49 million impact) – primarily steep rupee depreciation of 4.6% QoQ and 23.3% YoY – and a worldwide cyclical downturn in the infrastructure/engineering business (4% of revenue). On a constant currency basis, IT services revenue rose 19.2% YoY and 3.5% QoQ compared with less flattering realized figures of +12.4% YoY and -0.9% QoQ. Wipro recorded acceptable QoQ progress across key operating metrics (page 5): volume (+2.2%), blended revenue productivity (+1.2% on a constant currency basis), offshore revenuemix (+0.9%) and operating margin (+30 bps excluding a write-down necessitated by the Nortel bankruptcy). However, it also posted lower headcount (-0.6% attributed to a preference for need-based hiring vs. maintaining a large bench plus non-linear initiatives) and client-count (-2.6% due to completion of projects for smaller clients), along with stubborn attrition (involuntary exit of underperforming employees).

On a constant currency basis, core IT Services revenue exceeded guidance by 0.4%. Areas of relative strength included the Retail & Transportation vertical (+11.4% QoQ); Europe (+7.5%) and the India & Middle East region (+5.5%); and the Package Implementation practice (+3.7%). Weakness was noticeable across the Technology segment (-3.8%) while Financial Services stood firm (+2.1%). Operating income of $218.0 million (16.2% margin) fell short of our $230.6 million estimate (16.3% margin) due to a deficit in the infrastructure business and a non-recurring provision for one-half of Nortel receivables ($8 million). Profitability on a QoQ basis was aided by currency (30 bps), revenue productivity and offshore-mix – mitigated by the Nortel (NT) charge (60 bps) and recent offshore salary increases. We point out that Nortel contributes ~1.5% of revenue, the bulk of which is expected to hold steady in coming periods. In the IT Services segment, operating margin slipped to 20.0% from 20.3% in the immediately prior quarter. Wipro is confident of sustaining the operating margin within a narrow range in spite of clients pushing for price reductions. We note that Wipro did not implement its January onsite wage hike this year.

During the quarter, Wipro recorded four transformational wins – most coming against strong global players and validating its acquisition rationale. These included Origin Energy (SAP implementation), a U.S. data processing company ($100+ million managed services contract across Infocrossing data centers) and a U.K. food retailer (large-scale process change on the Oracle (NYSE:ORCL) ERP platform). To enhance its relevance in the current environment, Wipro has introduced a new suite of offerings, e.g., an Application Rationalization service will enable clients to reduce cost by 15-20% while improving operational efficiency. Additionally, it is responding to client needs through innovative delivery models (SaaS and outcome-based pricing) and proprietary industry-specific solutions.

Management cited the Financial Services and Technology sectors – and likely delays during reassessment of annual spending priorities – to explain surprisingly soft 4Q09 IT Services revenue guidance, i.e., 6.8% QoQ contraction on an organic, constant currency basis. Chairman Premji offered a sober outlook for 2009 and acknowledged that the fragile global economy is impacting business across segments. Still, Wipro is strongly positioned to meet client requirements, i.e., with integrated offerings that reduce overhead associated with managing multiple relationships, steadfast loyalty during a difficult period, ability to lower operating expenses and conserve capital (see process optimization services above), and undisputed financial strength and integrity.

Wipro has not felt any adverse fallout from the Satyam (SAY) scandal. It is not soliciting Satyam clients – but being duly responsive when approached for business continuity planning. Like Infosys (NYSE:INFY), we commend Wipro for its voluntary disclosure of cash balances held at all financial institutions. However, any move to discontinue (already limited) guidance – even if this is rendered less meaningful due to currency distortions – would represent a step backward.

In January, Wipro acquired from Citigroup (NYSE:C) its India-based captive IT unit. Excluding cash, the $101 million purchase price translates into a reasonable 1.3x LTM revenue, 3.3x EBITDA and 3.8x net income. Terms include a $500 million revenue commitment over six years and preferred vendor status. Citi Technology Services (CTS) with its 1,650 employees will strengthen ADM and infrastructure management competencies for cards, capital markets and corporate banking. The all cash acquisition should be nominally accretive to EPS and allow Wipro to address complex banking engagements worldwide. Exposure to Citi Holdings (bad bank) is limited to ~10% of CTS revenue.

The underlying philosophy of Wipro’s hedging program calls for upfront protection against future rupee volatility – covering 20% of net inflows from long term contracts. At present, potential loss of revenue and EPS upside on outstanding hedges (caused by steep rupee depreciation) stands at $324 million over 3-4 years, or ~$25 million per quarter (EPADS impact = 1.5 cents). This figure is marked to quarterly USD/INR movements. Additionally, to shield USD investments ($600 million Infocrossing acquisition) from currency risk, Wipro has established a $350 million yen-based loan swapped into USD. Accordingly, the Indian GAAP balance sheet it is protected to this extent against USD/INR movements. However, this natural hedge does not qualify for cash flow hedge accounting under U.S. GAAP, which remains exposed to quarterly USD/INR cross-currency translation losses (-$14 million in 3Q09 recorded in interest/other income). Finally, balance sheet translation on all outstanding hedges is reconciled at quarter-end under forex gains/losses (+$3 million in 3Q09).

WIT shares are suitable for aggressive investors. In our opinion, principal risks include the following: U.S. slowdown; rising offshore salaries; appreciation of the Indian currency, which would translate into higher expenses incurred in rupees; correction in the Bombay Stock Exchange and/or markets; political opposition in the U.S.; and geopolitical uncertainty in the Indian subcontinent.

Disclosure: I, Ashish Thadhani, certify that all the views expressed in this research report accurately reflect my personal views of the subject companies. I certify that I have not and will not receive compensation with respect to the issuance of this report.

Source: Wipro: Despite Headwinds, Results Should Prove Resilient