Indian IT/Offshoring Quarterly Snapshot: Cognizant Top Bellwether Pick

Ashish R. Thadhani (Gilford Securities) recently sent a note to clients overviewing the performance and outlook of several India offshoring/IT firms. Excerpts follow:

MACRO OBSERVATIONS & COMPANY DEVELOPMENTS

Offshoring stocks remain weighed down by rupee appreciation, which has reached disconcerting levels: up 6% QTD. Current guidance from the IT bellwethers assumes exchange rates of INR 41-43 per U.S. dollar, implying EPS estimates could be at risk. We note that a 1% currency swing can impact pretax margin by 20-40 basis points, depending on a company’s cost structure and hedging policy. Cognizant (CTSH) has the least exposure to such external factors, although a near-term focus on margin levers suggests that the historical cushion may be eroding. On a more reassuring note, quarterly results indicate healthy U.S. demand, as well as client willingness to share the burden of rising wages through modest price increases. Offshore salary hikes averaged 14-16%, as expected. Satyam (SAY) delivered a stand-out performance with 9.5% QoQ revenue growth, improvement in employee attrition to 13% from 22% last year, rising billing rates and surprisingly strong EPS guidance for the current year. Other highlights were 45% YoY organic revenue growth at Infosys (INFY), profitable integration of all acquisitions plus unmatched BPO margins at Wipro (WIT) and an industry-leading EPS outlook at Cognizant. Noteworthy sector developments have included a continuation of merger activity, i.e., announced $1.3 billion acquisition of Covansys (CVNS) by CSC; filing of an IPO registration statement by Genpact; and resurfacing protectionist rhetoric ahead of the Presidential election -- even as India-based headcount of IBM (IBM), Accenture (ACN) and EDS (EDS) crossed 100K.

FAVORITE STOCKS

On the basis of projected upside, Cognizant (+37% in 12 months) ranks as our top bellwether pick at this time. Looking beyond offshoring names, Rediff (REDF) (+39%) offers greater but more speculative appreciation potential. Based on revisions to our calendar 2007 GAAP EPS estimates, Satyam (+12%) posted the best March quarter results.

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• Nasdaq vs. Sensex: latter has outperformed by a large margin.
• Moderation of earnings growth ... factored into valuation?
• Foreign and domestic institutional activity: positive international interest outpaced by local inflows in recent periods.
• Individual stocks: outsized returns ... and risks.
• 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 can impact operating margin by up to 40 bps.

IT SECTOR TRENDS

• Growth: Cognizant owns best record (13% LTM QCGR).
• Profitability: wide range explained by management, scale and reinvestment philosophy; productivity levers include employee- and offshore-mix.
• Attrition: key indicator of wage inflation, which has translated into ~300 bps of margin pressure annually.
• Talent: gap between market demand and employable graduates is cause for concern and being addressed by training & development initiatives.
• Direct employment: 1.6M, up 26% YoY.
• Sector outlook: $60-80 billion NASSCOM target implies 24-37% compound annual growth in FY07-10. Contribution to FY07 GDP = 5%.