Kotak Instl Eq cuts TCS, Infy to 'reduce'; lists negatives

Kawaljeet Saluja, executive director and head of research, Kotak Institutional Equities said the brokerage firm has downgraded the IT sector to 'cautious' today, adding that the Nasscom guidance of 11-14% growth for the industry looks quite 'aggressive'.  

Yesterday, Infosys shocked the street with its 5% revenue growth guidance for the full fiscal against the 8-10% it projected in April. But TCS' results were above market expectations, indicating the problems faced by Infosys may not be industry wide.
The two companies account for nearly a quarter of India's software exports.
TCS does not make revenue or profit predictions, but on Thursday, Infosys stopped the practice of guiding for the next quarter saying conditions were too volatile.
Nasscom has forecast that the IT industry will grow 11-14% in the year to March 2013. Saluja expects the industry to grow at 8-10%, while he sees TCS growing at 11-12% in FY13.
However, he informed that his Kotak has downgraded both TCS and Infosys to 'reduce' earlier today. "We have cut TCS target to Rs 1,125 a share from earlier 1,280 a share, while Infosys trade has been reduced to Rs 2,350 a shared from Rs 2,850 a share earlier," Suluja told CNBC-TV18 in an interview. Below is an edited transcript of the interview on CNBC-TV18. Q: How did TCS perform in terms of earnings?
A: TCS reported a good performance pretty much in line with our estimate. Their dollar revenue growth, EBITDA margin, net income was in line and they continued to execute well. The strong execution is reflecting in a solid financial performance and recent stock performance as well. Q: Can it continue to defy the sluggishness in the macro environment overall? They have been beating it every quarter so far and the management sounds confident, but would you expect the environment to catch up with them in the remaining quarters of the year?
A: We expect the industry to grow at lower than what the NASSCOM has guided at around 8-10% in FY13. As far as TCS is concerned, they have been executing better. So they might grow a little bit better than our forecast of industry. They might end up growing by 11-12%.
But I guess it does not takeaway from the fact that there is a slowdown in the market and the key focus areas of Indian IT companies which is the North America, BFSI and telecom axis has actually shown a material deterioration in the spending trends. This will basically reflect in performance of all companies including TCS. Within the sector, there would be been certain companies which would perform better, then there would be certain companies which would perform weaker depending on the business portfolio mix and the execution strategy. Q: Have you marked down your numbers significantly after Infosys delivered yesterday, what are your new EPS or price target projections for that stock?
A: Before I talk about Infosys, let me just highlight that we have downgraded the entire IT services space from an attractive coverage view to a cautious coverage view. We have downgraded all tier-I IT names to a reduce/sell rating. Now specifically on Infosys, what we have done is essentially cut our earnings estimates by 2-9% for the next two years and cut target price to Rs 2,350 from Rs 2,850 earlier. Q: TCS says it will beat the NASSCOM guidance but what looks more likely that NASSCOM brings down their own guidance and then TCS says we are still on a beat mode over here or do you think NASSCOM holds their guidance which will actually be a huge slap in the face for the company like Infosys where everyone is saying more optimistic things than them?
A: As I said earlier, I believe that the NASSCOM guidance of 11-14% is aggressive. What we are looking at internally is a revenue growth of 8-10% for FY2013 and we are expecting TCS to grow at 11-12% for FY13 overall. So in any case, we don’t expect the industry to grow at the same rate. There has been a marked deceleration in growth, new deals flows in the financial services and a host of other verticals, and that in a way, would make for the industry to achieve the NASSCOM growth target all the more challenging.
_PAGEBREAK_ Q: Wipro is the stock that has lost more than 7% in the last three days. Do you think the market has a sense of what is coming?
A: If you just look at the results of Infosys and TCS, the one interesting element has been a pricing correction, more dramatic in the case of Infosys, just modest in the case of TCS. But if you look at the trend of last four-five quarters, the pricing on an average for both Infosys and TCS has corrected.
As far as Wipro is concerned, they are under pressure to basically align revenue growth with the industry. I would not be surprised if that would be some tactical move and there could be some pricing adjustments as well. So I guess just in the case of Infosys and TCS maybe Wipro will also have a little bit of pricing correction in the current quarter. Q: This Rs 2,350 target that you spoke about Infosys, what is it predicated on in terms of a P/E multiple and based on what EPS estimates for FY13 and FY14?
A: FY13 EPS for Infosys is Rs 166 and for FY14 is Rs 172. The implied P/E multiple is 14 times on FY2013 earnings for Infosys. As far as the sector is concerned, we have moved the target P/E multiple from the upper end of the mid-cycle band to the lower end of the mid-cycle band. This means the P/E range for various companies is something, which we have brought down in the 13-16 times versus 16-18 times earlier. Q: What is the overall sectoral downgrade based on? What makes you circumspect that their macro environment will hurt most companies in the sector?
A: TCS is confident on revenue growth. The fact is that Infosys conceding on pricing is a very negative sign. We already have two tier one IT players who have been aggressive on pricing to gain share of business. Now Infosys letting go of pricing to basically at least tame the loss of share of business is a very negative signal for the industry. We believe that this pricing behaviour is something which will manifest in performance of various IT companies over the next six to nine months, and correspondingly, earnings downgrade.
If you look at it fundamentally, this industry or way the tier one IT companies have grown historically is through a cyclical growth in offshore deals along with consolidation in the number of tier one players. However, in the last three years the number of tier one players, instead of consolidating, has expanded. HCL Tech has basically become very aggressive in the market place and basically bought relevance. You have IBM and Accenture which were not as present in the offshore deals as they are now. Then on top of that, there are top three players who are extremely hungry for growth which is Infosys, TCS and Wipro.
Suddenly, when an industry, which had three-four tier one players, today has seven players, it is against the backdrop of increasing the shrinking pie. Obviously, the growth aspirations of not all the players would be met in the current environment and that will manifest in a different pricing behaviour or aggressive pricing behaviour by different players which can in turn impact the freedom of IT industry. So, that in a sense is the basic thesis or theme under which we have downgraded the sector. Q: You are not a big fan of the polarization argument. By when do you think we will start seeing convergence amongst these companies in terms of all of them facing the same problems?
A: Yes, that is what our basic theme is that eventually either the industry will give way on pricing and there will be earnings downgrade across the sector. Q: Things are actually a lot more smooth and less volatile for the midcap IT faces. Do you agree with that and is there more consistency that you see on any specific names there?
A: We take a stock of our recommendations on midcap IT. Obviously, many of the names have done extremely well. The two names which we have been positive on are Hexaware and MindTree. They have delivered consistent performance which is affected in a way in financial performance and stock performance as well. In any case, as far as the current quarter is concerned, most of the companies will have a soft quarter on growth except Hexaware. Q: What do you expect to hear from HCL Technologies?
A: I expect HCL to deliver a reasonable quarter maybe 1.7-1.8% dollar revenue growth, which will be better than the growth rate, which is likely to be reported by the two Bangalore players. So yes, the growth rates will be better. Essentially, better growth rate would be a function of the aggressive deal wins over the last two quarters, which would act as a good base for growth in FY13.