Indian Outsourcing Quarterly Snapshot: Cognizant Top Bellwether Pick

Excerpts from Ashish R. Thadhani's (Gilford Securities) recent quarterly snapshot to clients on the India IT/offshoring sector:

MACRO OBSERVATIONS & COMPANY DEVELOPMENTS Investor focus has shifted squarely to fallout from the credit and housing marketplace, as well as slightly soft December quarter guidance from Cognizant. These events have raised concern over client IT budgets in 2008. Following a 9-30% pullback, offshoring bellwethers are currently selling at an inexpensive 21-25x forward EPS – or 0.9-1.3x compound EPS growth in calendar 2007-09E – after factoring in expiration of prior tax benefits.

In the September quarter, all of the majors posted reassuring growth in the Financial Services segment (24-47% of revenue). Since then, we have raised our EPS estimates for Infosys, Cognizant and Satyam. The latter recorded industry-leading 12.7% QoQ growth. Notably, revenue productivity (pricing) at Infosys has improved by more than 5% YoY for four straight quarters, an encouraging trend that could aid meaningfully toward neutralizing annual wage pressure. Furthermore, operating margin held up surprisingly well vs. last year despite a stiff 600 bps currency headwind! Most companies are also adopting a more aggressive forex hedging posture. Meanwhile, TCS signed the largest multi-year deal by an Indian IT company ($1.2 billion).

We believe that fears of an abrupt slowdown in offshoring activity are overblown. Current indications point to flat or modest growth in 2008 IT budgets with a rising allocation for offshore initiatives – a vast majority of which do not fall into the discretionary category. Nonetheless, for a recovery in share prices, clearer visibility into client spending plans and diminished currency volatility remain essential prerequisites.

FAVORITE STOCKS On the basis of projected upside, Cognizant (CTSH) (+59% in 12 months) ranks as our top bellwether pick at this time. Based on revisions to our calendar 2008 GAAP EPS estimates, Satyam (SAY) (+5%) once again posted the best quarterly results.

MARKET INTELLIGENCE

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• Nasdaq vs. Sensex: emerging markets may offer temporary refuge from a moderate slowdown in developed economies.
• Reward/risk: valuation likely to remain a function of overall earnings visibility and global risk appetite; figs. include index change, recent results.
• Foreign and domestic institutional activity: positive international interest outpaced by local inflows in recent periods.
• Nifty winners and losers: IT majors out of favor.
• 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 up to 50 bps.

MACRO INDICATORS

IT SECTOR TRENDS