JPMorgan, What do Asia investors think about Indian IT? - Three cues to consider buying of select Indian IT stocks

Over the past week, we met a cross-section of Asia-based investors (about 30 in all) of
various investment hues in Hong Kong/Singapore to discuss the Indian IT sector. The
consensus view is that the sector’s valuations could see some downside in the near
term. For example, TCS’ valuation of 17x FY13E P/E is perceived as expensive in the
context of India’s market valuation and the absence of meaningful consensus
downgrades in India IT. By and large, investors are inclined to sell into a potentially
sporadic rally created by the rupee depreciation and other temporary favorable
factor(s). The focus on our meetings centered on spotting cues for timing the
buying of front-line Indian IT stocks. Should investors buy India IT? If so, when?
We present three circumstances/indicators that we believe investors should consider in
order to consider their buying of Indian IT stocks:
 Indicator 1: when we get feelers about the CY12 IT budgets: In our view, CY12
budgets that are flat-to-low single digit down, in aggregate (vs. CY11 as %), could
be a driver for IT stocks. The market currently fears a difficult CY12/FY13 (perhaps
factoring in severe IT budget cuts (in aggregate terms) well exceeding 5%). In fact,
on-time indicators of the direction of the budgets themselves are a positive as clients
tend to push out decision-making on budgets in such times (recall 2009 when the
process of budget-setting was severely delayed).
 Indicator 2: when consensus brings numbers down. As we noted in our Sep. 12,
2011 Note, “Consensus is a perverse predictor of stock price movements - it rarely
gets the turn of the cycle right,” seeing consensus bringing numbers down is a
starting signal to think in terms of buying, not selling. So, far we note that
consensus FY13E EPS of Infosys of (Rs159) has some distance to travel to our
FY13 EPS estimate of Infosys of Rs150. As the previous 2008 downturn showed,
consensus rarely captures the “turn of the cycle” (or inflection points) and by the
time consensus comprehends the cycle turn and adjusts itself, stocks will likely start
exhibiting contrary/opposite moves. In 2009, stocks bottomed when consensus came
off just a fraction (typically 20-40%) of eventual length of full consensus
downgrades. We present several charts in support of this thesis.
 Indicator 3: FY13E P/E at 12-13x is a target multiple to buy and not to
capitulate. Should front-line Indian IT stocks become much cheaper, it
behooves us to do analysis of what medium-to-long term expectations are priced
in. As a rule of thumb, 5% perpetual growth translates into a forward P/E multiple of
~12-13x (also corroborated using the equation steady-state multiple = 1-(g/ROIC)/
(cost of equity – g). P/E of 12-13x on FY13E should be a signal telling us that
Infosys/TCS are pricing in no more than 5-6% growth in perpetuity starting
FY13 (or no market share gains by India IT hereafter).
 Investment view. TCS (OW), our top pick, is the most over-owned India IT stock
among Asia investors. Broadly, it also has a significant overweight position in client
portfolios relative to its index weight. This technical aspect is causing some clients
to be cautious about the stock. Barring moderated valuations, Infosys (rated Neutral)
does not inspire much confidence among investors. We believe Investors are also
less confident about Wipro’s ability to turn around and would not mind sacrificing
some upside before taking another look. We think Wipro could be the dark horse,
macros permitting. Investors are not able to paint HCLT’s longer-term margin
profile for longer-term investing in this stock.