Indian IT/Outsourcing Outlook: Wipro, Satyam Remain Top Bellwether Picks

Ashish R. Thadhani (Gilford Securities) recently sent a note to clients analyzing opportunities in Indian IT Services/Outsourcing sector. Excerpts follow:

MACRO OBSERVATIONS & COMPANY DEVELOPMENTS
Reassuring December quarter results – achieved in spite of a stiff currency headwind (80-200 bps impact) – as well as a backdrop of rising fiscal 2007 GDP forecasts have been overshadowed by other developments. These include market volatility in China, unwinding of the yen carry trade and signs of fickle commitment to emerging market equities; budget measures that will prematurely impose taxes on the IT sector (although offsetting deferred tax assets should shield earnings); and renewed concern over Sensex valuation, climbing interest rates and inflation (a factor in recent state elections). Nonetheless, quarterly results reflect healthy discretionary spending and continuing expansion in the size/scope of new engagements, firm underlying profitability and initiatives to enhance “employability” of the graduate pool in India. We recently raised our GAAP EPS estimates for Infosys (INFY), Wipro (WIT), Cognizant (CTSH) and Satyam (SAY). However, we have downgraded our rating on Tier-II player Syntel to Hold due to valuation, fundamental and management reservations. Key items to monitor include upcoming fiscal 2008 guidance from Infosys, which will address the sustainability of above-trend growth and operating profitability; performance of prior acquisitions at Wipro; employee attrition at Cognizant; the ability of Satyam to invoke available margin levers; plus industry-wide offshore salary increases beginning in April.

FAVORITE STOCK(s)
On the basis of projected upside, Wipro and Satyam (+25% in 12 months) rank as our top bellwether picks at this time. Looking beyond offshoring names, recently upgraded Rediff (REDF) (+40%) offers greater – albeit more speculative – appreciation potential. Based on revisions to our calendar 2007 GAAP EPS estimates, Cognizant (+10%) delivered the best December quarter results.

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• BSE market cap. was $822B at end-December. Drivers of long-term GDP growth (est. at ~9% in FY07) are policy reforms and demographics.

• 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 the level of rupee-denominated expenses, 1% rupee swing could impact operating margin by up to 50 bps.

• Revenue growth: Cognizant owns best record (13% LTM QCGR).

• Operating profitability: productivity levers include more work done at offshore locations and emphasis on entry-level hiring.

• Attrition: key indicator of wage inflation, which has translated into ~300 bps of margin pressure annually.