India IT Quarterly Snapshot: Cognizant Top Bellwether Pick

Excerpts from Gilford Securities analyst Ashish R. Thadhani's recent quarterly update to clients on the Indian outsourcers:

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MACRO OBSERVATIONS & COMPANY DEVELOPMENTS

We remain constructive on the offshoring majors and believe that escalating pessimism could provide a compelling valuation opportunity (the average forward P/E currently stands at 18x vs. 33x a year ago). Understandably, prevailing sentiment reflects heightened uncertainty over U.S. IT spending (60-81% of company revenue). Without appearing dismissive of the unfolding scenario, managements have noted healthy pipeline activity; no abrupt project cancellations; and a view that offshoring represents a proven value proposition for clients seeking cost efficiency in a challenging macro environment.

Cognizant (CTSH) is undoubtedly the most confident about its 2008 prospects (30% EPS growth), while Infosys (INFY) has acknowledged the potential for a modest short- term deceleration due to delayed finalization of client budgets and new projects. Positives, somewhat overlooked of late, include a cooperative currency – the INR has retreated 2.8% in 2008 implying 50-125 bps of margin tailwinds; meaningful 6% YoY pricing gains at Satyam (SAY) and Infosys; some 21 large wins ($50+ million) for the top-four (U.S. listed) offshoring players in the December quarter; and anticipated easing of annual offshore wage increases to the 10-12% range in April 2008 vs. 12-18% in recent years. In late-February, the Budget ignored industry demands for an extension of STPI tax benefits beyond March 2009 – but this outcome was not entirely unexpected.

Finally, we note that Wipro (WIP) now ranks as the second largest Indian IT services company – behind TCS – including its Asia-Pacific business and recent acquisitions.

FAVORITE STOCKS

On the basis of projected upside, Cognizant (+71% in 12 months) ranks as our top bellwether pick at this time. Based on revisions to our calendar 2008 GAAP EPS estimates, Satyam (+2%) yet again posted the best quarterly results.

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• Nasdaq vs. Sensex: emerging markets may not offer refuge from a full-blown downturn across developed economies.
• Valuation: likely to remain a function of overall earnings visibility and global risk appetite.
• Foreign and domestic institutional activity: positive international interest outpaced by local inflows in recent periods.
• Nifty winners and losers: IT majors still 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 20-50 bps.

• Economic growth: long-term drivers are policy reforms and demographics; consolidated figure masks Agriculture drag and poor infrastructure.
• BSE market capitalization: $1,819B at end-December or 1.6x forward GDP.
• Inflation: imperfect gauge -- currently within a targeted 4-5% range; energy and food prices could exert upward pressure.
• Interest rates: bias could shift toward easing.
• Dollar purchases by RBI: $75B (net) during the preceding four quarters.
• Forex reserves: $301B as of end-February.

• Growth: Satyam owns best record (10.6% 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.
• Offshore price realizations: potential margin lever, driven by business-mix and ramp-up of newer clients.
• Outlook: $60B NASSCOM target implies 24% compound growth in FY07-10 and 20% market penetration; FY08E GDP contribution = 5.5%.
• Prevailing sentiment: conveys concern over a U.S. economic slowdown, as well as a shortage of employable graduates and strong rupee.

Comments

[ShaneMilburn]

Thanks for posting the summary above. I've also noticed the conference call comments from both INFY and CTSH seem quite a bit more favorable than the recent price action of stocks would indicate.