29 Nov 2012

Technology

TECHNOLOGY: Takeaways from management meetings; Expect

3Q to remain soft; Decision making continues to be slow

We met with managements of IT companies to get a sense on CY13 client budgets

and their expectations for the current quarter. Key Takeaways:

−

While it is still early to ascertain clients’ budgets for CY13, companies are not

worried about the same. Deal pipeline is not shrinking, suggesting continued

growth. However, discretionary spending remains weak and decision making

continues to be slow.

−

3QFY13 is expected to be a weak quarter. Furloughs are likely to impact onsite

volumes at some companies as much as 4 working days (6% of onsite volumes

assuming a 65 working day quarter). Given anticipated drop in utilization,

margins too are likely to soften.

−

Pricing discipline has been maintained by competition at large and companies

do not expect any pressures on that front. Outlook remains for stable pricing.

1. HCL TECH: Expect strong deal signings led by higher win rates,

healthy pipeline; margins to remain above 16.5%

‐

‐

‐

‐

‐

Deal pipeline of HCL Tech (HCLT IN, CMP INR643, Mkt cap USD8.1b, Buy) in ITO

remains healthy with USD61b worth of deals in the market expected in 2HCY12.

Total deals in CY13 is expected to increase to USD120b from USD102b in CY12.

HCL’s win ratios in the past have been 25‐30% and have improved now. The

company would be disappointed with win ratios of less than 40%.

ITO and IMS market remain lucrative. Of the total USD273b worth of churn deals

expected between Oct 2012 – Dec 2014, two‐thirds fall in these two segments.

Healthy deal pipeline coupled with improved win ratios indicate likelihood of

strong TCV of deal signings in the next two quarters.

While the opportunity in ITO / IMS have made other players focus on these

segments as well, HCL expects its early mover advantage and higher end

capabilities in full ITO deals to hold it in good stead.

Margins are expected to be stable. Residual impact of wage hikes and increased

investments in hunting are headwinds to the margins, but the company expects

gradual improvement in the pyramid and maturation of large deals to help

offset the same.

The stock trades 13.2x FY13x and 12.6x FY14E. Higher revenue growth visibility

at HCL compared to peers coupled with healthy margin performance make a

case for higher multiples. Maintain Buy with TP of INR712 (14x FY14 EPS), 11%

upside.

1

Technology

Renewal deal pipeline remains healthy, improved win ratios will help grab sizeable

TCV of deals

−

Deal pipeline in ITO remains healthy. Of the USD61b worth of deals in the

market expected in 2HCY12, USD25b were reported in 3QCY12 and USD36b are

expected in the last quarter.

−

Total deals in CY13 are expected to increase to USD120b in from USD102b in

CY12. TPI’s estimate for deals in CY14 is USD113b.

−

While HCL Tech earlier used to have win ratios of 25‐30%, it has gone on to

improve the same. 1QFY13 win ratio was 51%. While this was an exceptional

quarter, the company suggests that win ratios below 40% will be disappointing.

This augurs well for the total TCV of deals signed during the deal closure‐heavy

period.

USD61b worth deals are expected in 2HCY12

Majority of the deals in the next 9 quarters are in IMS and full ITO

Not worried about competition; ITO constitutes the largest proportion of deals

−

The increased number of deals TCV in the churn market has made the space

lucrative for more players than HCL alone, as a result of which competition is

likely to be higher. HCL has been largely competing with the likes of IBM,

Accenture and Cap Gemini in the past.

−

The company however, is not perturbed about the increase in competition from

Indian vendors. Of the total USD273b worth of deals expected between Oct

2012 – Dec 2014, USD184b are in ITO / IMS. These are HCL Tech’s strength, and

while the opportunity has made other players focus on them, HCL expects its

early mover advantage and higher end capabilities compared to peers to hold it

in good stead.

While RTB will drive growth, CTB will not be dismal despite challenged

discretionary spending

−

Weak macro has meant that majority of the deals fall in the RTB (Run‐The‐

Business) space, while CTB (Change‐The‐Business) spends remain sluggish. The

company expects RTB spends to drive growth going forward given plenty of deal

opportunities presented by the pipeline.

−

However, the company is not very worried around growth in the EAS segment,

despite muted spends on smaller discretionary projects in the medium term. It

has successfully managed to unlock capital in clients’ CTB spends after making

entry through RTB spends. Additionally, significant acceleration in transition to

29 Nov 2012

2

Technology

cloud based solutions and Mobility solutions are showing fast growth, albeit on

a small base.

EAS declined QoQ, while IMS drove growth during the quarter

Does not expect margins to breach guidance as multiple headwinds will be offset

by tailwinds from growth

−

Margins in 2QFY13 will see headwinds from: [1] residual impacts from wage

hikes (100bp QoQ impact), [2] increased investment in hunting (SGA has come

down by 140bp from 14.4% in 2QFY12 to 13% in 1QFY13) and [3] Transition

costs in the new deals expected to kick‐start after deal signings during the

quarter.

−

Also, the company saw multiple levers exercised in FY12 that aided margin

expansion apart from currency: [1] Utilization including trainees is the highest in

the last 10 quarters (74.2%), [2] Revenue from Fixed price contracts improved

720bp YoY to 51.2% and [3] Revenue proportion from offshore expanded 200bp

YoY to 44.3%

−

Despite the headwinds and significant extraction of tailwinds, HCL Tech expects

growth and continued maturity of large deals will help it maintain its margin

above 16.5%, as there may be room for more offshoring and also, more

significantly, improvement of the employee pyramid, two of its key margin

levers.

Multiple revenue levers have been exercised, driving uptick

in margins, apart from benefits from currency

2.TECH MAHINDRA: Multiple trends drive positive outlook on

organic growth outside BT; Focus on client mining continues at

Satyam; Buy with 29% upside

‐

Internal cost optimization at BT has been hurting revenues from top‐account for

Tech Mahindra (TECHM IN, CMP INR893, Mkt cap USD2.1b, Buy). Revenues from

the account are expected to remain sluggish despite some growth from

broadband and data segments.

29 Nov 2012

3

Technology

‐

‐

‐

‐

Outside BT, organic growth in Tech Mahindra is expected to at least match

industry growth. Trends like vendor consolidation, offshoring by potentially

under‐outsourced clients, emerging markets have kept the growth engine

fuelled.

Accounts like AT&T

continue

to hold potential to offshore more to the

company. Couple of recent large deals will result in an increase in the number of

clients in the higher revenue brackets.

At Mahindra Satyam, with annualized revenue per client at USD5.5m (USD8m

for larger peers), mining potential in remains significant, and can potentially

drive impressive growth. Pipeline in Manufacturing continues to be healthy.

While client‐specific traction has resulted in impressive growth at BFSI, the

company aims to diversify revenue base in the same.

TECHM trades at 10x FY13E and 8.5x FY14E EPS. We expect the company to

match, if not beat, industry’s performance, despite the exposure to the

challenged Telecom vertical, and estimate USD revenue CAGR of 12% over FY12‐

14 and an EPS CAGR of 22% during this period. Maintain Buy with a TP of

INR1150 (11x FY14 EPS), 29% upside.

Headwinds to revenue from BT on account of internal cost optimization

−

Revenues from BT declined 3.8% QoQ in 2QFY13 for Tech Mahindra, with

current quarterly run‐rate at USD98m. While re‐tendering activity did take a

breather, BT continues with its internal cost optimization measures, driving

expectation of sluggish revenues from the same. While there do not seem

chances of revenue uptick from BT, there may be some more declines in the

account, going forward.

−

Spends in Telecom have been muted and incremental spends have been driven

by the wireless segment, where BT’s limited presence has impacted IT spends.

However, within the account, there has been some growth in wireless and data

services segments.

Downward trend in revenues from BT may continue going forward

Growth in non‐BT accounts remains impressive, helped by HGS

acquisition revenues in 2Q

29 Nov 2012

4

Technology

Prospects of organic growth outside BT remain healthy

−

Tech Mahindra’s second largest customer continues to grow healthily for the

company, with significant room still existing to increase the wallet share. IT

spend at AT&T is multiple times that in BT, presenting opportunity for sustained

growth in that account going forward.

−

Also, ramps ups from deals signed like that with Royal KPN will add further

incremental revenues. Tech Mahindra revenues have been impacted negatively

by ~USD30m on account of Etisalat, order cancellation by Cox communications

and some rationalization in low margin Indian BPO accounts. There will be no

further impact YoY in FY14 from these factors

BPO has significantly outperformed other segments, driving revenue growth

Multiple trends driving growth; confident of growing in‐line with of better than

industry (ex‐BT)

−

Trends driving growth for Tech Mahindra are: [1] vendor consolidation, [2]

incremental outsourcing from under‐outsourced clients, [3] emerging markets

and [4] technologies like Network, Cloud, Mobility and Analytics.

−

The company is chasing two very large deals in the Managed Services space,

although decision making remains slow in the same. The segment currently

contributes 15‐16% to company’s revenues.

Mahindra Satyam: Mining potential will continue to be tapped to drive growth

−

Annualized revenue per client at Mahindra Satyam is ~USD5.5m, significantly

lower than that of larger sized peers, where annualized revenue per client is

upwards of USD8m for the larger peers. Given that the company has a

significant number of clients in F‐500 / G‐2000 space, the potential to mine

clients better is a clear opportunity that could drive growth. The company

continues to invest efforts in achieving the same.

Manufacturing and BFSI have been strong verticals for the company. Pipeline in

Manufacturing remains healthy. Revenue in BFSI, however, is concentrated

among few clients, and client specific traction has driven growth in revenues in

the vertical. The company aims to diversify its revenue base going forward.

29 Nov 2012

5

Technology

Growth at Satyam has accelerated over the past 3 quarters,

Manufacturing and BFSI have been stronger verticals

Margins to remain range‐bound at both the companies with wage hikes out of the

way

−

While full quarter revenue from HGS will impact margins at Tech Mahindra from

the next quarter, the company does not see any significant downward shift in its

margin trajectory. Cost optimization measures will help maintain margins within

a band.

−

At Satyam too, there are no significant headwinds to margins, with wage hikes

behind both the companies. Utilization at Satyam is 72.3%, a potential margin

lever. Also, if growth does come largely from top accounts’ farming, there will

be scale benefits helping margins.

TECHM: both EBITDA margin and Utilization have inched up in the last Satyam: Margins have expanded on multiple levers including SGA

rationalization

few quarters ,

3.PERSISTENT SYSTEMS: Traction continues in both IP‐driven and

non‐IP businesses; changing business mix augurs well for margin

profile

‐

Persistent’s (PSYS IN, CMP INR479, Mkt cap USD345m, Neutral) thrust on IP‐led

revenues saw the segment contribute 18.9% in 2QFY13. The company continues

to assess hundreds of potential products, in order to increase its IP‐driven

revenue portfolio, and is contemplating expanding its product managers team

significantly.

6

29 Nov 2012

Technology

‐

‐

‐

While decision making continues to linger, the company is witnessing strong

traction in the non‐IP businesses as well. On its small base, PSYS reiterated its

intention of outperforming Nasscom’s modest growth outlook for the industry.

Gross margins in the IP‐led segment have been ~50‐55% at the portfolio level.

While these require higher selling spends, in a couple of these products, PSYS

obtains royalty revenue on sales by its client, thereby implying no outgo of sales

dollars. Higher proportion of IP revenues are favorably changing the company’s

margin profile.

PSYS has progressively increased its payout ratio from 7% in FY10 to 15% in FY11

and 16.4% in FY12. It expects payout ratio to continue increasing going forward

too.

PSYS trades at 9.7x FY13E and 8.7x FY14E EPS. We expect PSYS to grow its

revenues at a CAGR of 16.5% over FY12‐14 and an EPS CAGR of 26% during this

period. We believe that re‐rating will be a function of: [1] Sustained healthy

margins – which faces challenge from high attrition and little room to increase

offshore mix and [2] Greater predictability on revenues. Early signs of the same

emanate from company’s expectation of at least USD32m annual revenues from

(currently) 5 revenue streams in the IP‐driven segment. Our target price of

INR495 discounts FY14E EPS by 9x. Neutral.

Heightened focus on IP‐driven revenues – continuing to scout for more products

−

Revenue proportion from IP‐driven businesses was a positive surprise at PSYS in

2QFY13. The company’s strong thrust on this segment indicates that revenue

contribution may further increase over time. Persistent is looking at hundreds of

products in the market, where it could seek to obtain the IP and add to its

basket of IP‐driven revenue streams. The company is also contemplating adding

significant number of product managers, who can drive the business with an in‐

depth know‐how of the product environment.

Currently, PSYS derives IP revenues from 5 sources – PaxPro, Doyenz rCloud,

Royalty revenues, connectors and Location business from OpenWave. Annual

stable revenue stream from these products currently stands at USD32m (~13%

of revenues 2QFY13 annualized revenues).

29 Nov 2012

7

Technology

T

USD r

revenue growth picking up with increasing contribution from IP

P‐

led bu

usiness ,

IP‐led reven

nues have seen a

a significant sur

rge in the last 4 quarters

on PSYS’ ass

set‐buying spree

e

Curre

ency and busines

ss mix shift in fav

vor of IP‐led revenues have help

p

grow margins

Traction in

n non‐IP busin

ness remains

s strong

−

While decision making continue to linger, the compan is witnessi strong

es

ny

ing

traction in the no

on‐IP busines

sses as well. On its sma base, the company

all

reiterated its intention of outgr

rowing the N

Nasscom’s mo

odest growth rates for

h

the ind

dustry.

−

It had earlier cited that deal pipeline has in

ncreased by 2

20‐25% v/s that in the

previou

us quarter. A

Also, it will ge

et back to hir

ring after 4 consecutive quarters of

net hea

adcount redu

uction, and will add ~600 n

net employee

es in 2HFY13.

Margin pro

ofile improve

ement driven

by changing

business mix

x

−

EBITDA margin at P

A

PSYS has mov up from 19% in 2QFY to 27% in 2QFY13.

ved

Y13

n

While currency m

made a sign

nificant contribution tow

wards the same, the

compa

any’s changing

g business m

mix in favor of

f IP‐led reven

nues has also played its

part. R

Revenues from

m IP‐driven se

egments cont

tributed 18.9

9% in 2QFY13

3, v/s 7.6%

in 2QFY

Y12.

−

Gross margins in th

he IP‐led segm

ment have be

een ~50‐55% at the portf

%

folio level.

While these requir higher sell

re

ling spends, in a couple of these PSY obtains

YS

royalty

y revenue on sales by its c

client, thereby implying no

o outgo of sales dollars

from PSYS. Higher proportion

of IP revenues are fa

r

avorably changing the

compa

any’s margin p

profile.

Progressively better payout ratio is expect

ted to continue t

to increase

Technology

Dividend payout likely to continue increasing

−

At the time of listing, PSYS had indicated that payout ratio would be between

10‐30%. The company has progressively increased its payout ratio from 7% in

FY10 to 15% in FY11 and 16.4% in FY12. It expects payout ratio to continue

increasing going forward too, which is a positive for the stock from valuations

perspective.

4.KPIT CUMMINS: Expect sequential revenue and margin decline

in 3Q; To raise debt following capital infusion

‐

3Q is expected to be a soft quarter for KPIT Cummins (KPIT IN, CMP INR128, Mkt

cap USD427m, Buy) with revenue expected to decline sequentially on account of

furloughs and the resulting drop in utilization is expected to drive QoQ margin

decline by 50‐100bp.

The company remains confident of bettering the lower end of guided revenue

band for FY13 (USD408‐418m). Its revenue in 2QFY13 was USD103.6m, and the

company expects to exit the year with at least USD108m, after a sequential

decline in 3QFY13.

KPIT’s impending cash outflows towards earn‐outs and raising the stake in

Systime from 76%

‐

100% are as follows: [1] USD15‐16m towards Sparta and

USD2m towards CPG in 3QFY13, [2] USD20‐24m towards increasing stake in

Systime to 100% in 1QFY14, and [3] USD3m in CPG in FY14. In INR terms, these

amount to INR2.2b by 1QFY14. The company has raised INR1.6b through capital

infusion and is expected to raise additional debt of ~INR1b.

Top account, Cummins, is expected to moderate in 3Q and revenues may be soft

going forward too. Cummins has announced cut in costs overall after a muted

outlook on revenue growth, and the same is likely to impact IT budgets too,

having direct implications for KPIT.

The stock trades at 11.8x FY13E and 9.8x FY14E EPS. While we remain positive

on the company’s fundamental business strengths offered by a differentiated

positioning, returns from current levels are limited by soft outlook in the near

term and recent upside in the stock (~11% in 2 weeks). Our target price of

INR144 (13% upside) discounts FY14E EPS by 11x.

‐

‐

‐

‐

Expect 3Q to be a soft quarter with sequential decline in revenue and margins

−

3QFY13 is expected to be a soft quarter for KPIT

‐

Revenue is expected to

decline sequentially on account of furloughs – resulting in loss of 4 days of

volumes QoQ and also due to closure of a project in top account Cummins,

impacting revenues by ~USD750k.

−

Also, the furloughs in the festive season are expected to impact the SAP

segment the most, driving drop in utilization in the same. Margins at SAP will as

a result, remain low, after falling to 7% in 2QFY13, as the company continues to

endeavor to align its skills post SAP’s acquisition of successfactors. As a result,

29 Nov 2012

9

Technology

T

USD r

recvenue expect

ted to decline se

equentially, a firs

st in 14 quarters

s

3QFY13 may see a QoQ decline in overall E

e

EBITDA margins in the ran of 50‐

nge

100bp.

.

EBITDA mar

rgin expected to drop in 3Q on a

account of lower

r utilization,

driven by fu

urloughs

Confident of meeting th

he lower end

d of the reven

nue guidance

e for FY13

−

Despite

e QoQ decline in USD reve

enues, the co

ompany expre

essed its conf

fidence on

beating

g the lower e

end of the rev

venue guidan

nce of USD40

08‐418m. Its r

revenue in

2QFY13 was USD10

03.6m, and th

he company e

expects to exi

it the year with at least

USD10

08m, after a se

equential dec

cline in 3QFY1

13.

−

Also EB

BITDA margin

n in 1HFY13 w

was 15.9% and the compan

ny expects to

o exit FY13

with at

t least 16%, d

despite sequential margin d

decline in 3Q

QFY13E.

−

PAT w definitely beat higher end of the guidance de

will

y

r

espite signific

cant forex

losses in 2Q, as the guidance wa

as based on IN

NR50/USD, w

while currency

y has been

signific

cantly more fa

avorable.

Expec

cts to better low

wer end of the re

evenue guidance

e in FY13

Exit margin may exceed 16%

%

To raise De

ebt in additio

on to recent c

capital infusio

on to meet im

mpending ear

rn‐outs

−

KPIT’s impending c

cash outflow towards e

ws

earn‐outs and raising the stake in

d

e

Systime from 76%

‐

100% are as follows: [1 USD15‐16m towards S

a

1]

m

Sparta and

USD2m towards CP in 3QFY1 [2] USD20

m

PG

13,

0‐24m towar increasing stake in

rds

g

Systime to 100% in 1QFY14, and

[3] USD3m in

n CPG in FY14

4.

−

Impend

ding earn‐ou up to 1Q

uts

QFY14 amoun to ~INR2.2 At the en of last

nt

2b.

nd

quarter, the compa had tota cash of IN

any

al

NR1.85b and debt worth INR2.38b.

Throug

gh capital infu

usion recently

y, KPIT raised

INR1.6b.

Technology

T

−

The co

ompany will raise debt in a

addition to re

ecent capital funding, amo

ounting to

~INR1b The injection of funds will take ca of the ea

b.

are

arn‐outs, and the cash

d

levels w

will not drop as a result, a

a cushion which the comp

pany wants to

o maintain

in case

e any acquisition materializ

zes.

Cummins e

expected to t

taper off goin

ng forward

−

Cummins accounte for 19.7% of the com

ed

%

mpany’s reve

enues in 2QF

FY13. The

accoun

nt is expected

d to moderate

e in 3Q and r

revenues may

y be soft goin

ng forward

too. Cummins has announced cut in costs overall after a muted outlook on

r

ue growth, an

nd the same is likely to im

mpact IT budgets too, hav

ving direct

revenu

implica

ations for KPIT

T.

−

KPIT enjoys ~50% of the IT spe from Cummins, follo

end

owed by TCS and then

Infosys ~60% of th revenues from Cummin are towards business IT services

s.

he

f

ns

and the

e remaining t

towards Engin

neering.

Top client lik

kely to underper

rform company average perform

mance going for

rward following

g

commentary

y by Cummins

Looking for acquisitions

s in the engin

neering space

e and small p

pockets in SAP

P

−

The co

ompany cont

tinues to sco for acquisitions most in the En

out

tly

ngineering

space. In the Enter

rprises services segment, KPIT largely has the capa

abilities in

place, apart from so

ome pockets in SAP.

Acquisitions are no expected to

ot

o exceed the size of some of company’s recent

e

forays, thereby ind

,

dicating no significant de

s

eterioration of the Balan sheet.

nce

Organic capex of the company is

s expected to stay at ~USD

D7‐8m annually.

Technology

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29 Nov 2012

12