Satyam an outperformer; target of Rs 542

Event

Using our proprietary margin analysis framework, we conclude that for FY08, there will be an EBITDA margin erosion of 261bps for Satyam. However, we believe Satyam is a good candidate to cross the tier-1 valuation chasm based on strong revenue growth, its converging ROE with Infosys and focus on high-growth engineering services business. We maintain our long-term Outperform rating on the stock, but cut our FY08 EPS forecast by 7%.

Impact

In our proprietary margin analysis, we quantified the effect of ‘sorrow’ factors like a stronger rupee regime (Macquarie’s forecast for FY08 is Rs 40.3 per USD) and wage inflation, and ‘joy’ factors like pricing power and various productivity gain levers. Satyam has USD 650 million of hedging on its books. Based on the 58% natural hedge available to the company and our economics team’s exchange rate forecasts, our calculations suggest that the realised Re rate for Satyam in FY3/08 will be Rs 42.5 per USD. Re appreciation will shave of 248bps from Satyam’s EBITDA margin in FY3/08. Rising wages will dent this by a further 466bps. We have assumed a 15% rise in offshore wages and a 4% increase in onsite wages. The above negatives will be partially offset by levers like better pricing power (163bps), productivity gains (75bps), improvement in the offshore-onsite mix (19bps), an increase in utilisation (22bps) and SG&A leverage (173bps).

Earnings revision

Because of adverse exchange rate movement, we have cut our FY3/08E EPS from Rs 25.8 to Rs 24.0 and our FY3/09E EPS from Rs 31.7 to Rs 30.9.

Price catalyst

12-month price target: Rs 542.00 based on a PER methodology. Catalyst: Large deal wins (>USD 50 million) or an acquisition to penetrate Europe/Japan or building product capabilities.

Action and recommendation

We have cut our earnings forecasts marginally as well as our price target. We maintain our Outperform rating on the stock, with 16% upside from the current level. In the short term, there could be some weakness as Satyam may cut its guidance for FY3/08. However, for long-term investors, it remains an attractive pick in our view.



Neutral on Wipro

Event

Using our proprietary margin analysis framework, we have quantified the effect of ‘sorrow’ factors such as a stronger Rupee regime (Macquarie forecast for FY08 is at Rs 40.3 per USD), wage inflation and ‘joy’ factors such as pricing power and various productivity gain levers. We conclude that for FY08, there will be an EBITDA margin erosion of 388bp for Wipro. This large impact (relative to its peers) is due to its weak hedging position (2 months of net forex inflows compared with the 4 months for Infosys and 7 months for Satyam); coupled with absence of software business and limited pricing power. We downgrade the stock to Neutral from Outperform and cut our FY08 EPS forecasts by 20.3%.

Impact

Wipro has the least amount (USD 600 million) of hedge available among the Tier-1 IT companies. This is sufficient to protect margins only till June 2007. For the full FY3/08, the average realised USD/Rs exchange rate works out to Rs41.1. The rupee appreciation should reduce the EBITDA margin in FY3/08 by 467bp, which is the highest compared with its peers. Rising employee cost, both onsite (4%) and offshore (15%), will result in further decrease in EBITDA margins by 443bp in FY3/08. Coming to some rescue of the EBITDA margin are the levers such as higher price realisation (111bp), productivity gains (78bp), further offshore movement of work (19bp), increase in utilisation (13bp) and SG&A leverage (300bp). We note that Wipro’s margin protection levers are small primarily due to a weaker pricing power and absence of software products business.

Earnings revision

Owing to the negative exchange rate movement, we reduce our EPS estimates for FY3/08 and FY3/09 from Rs 25.2 and Rs 31.1 to Rs 19.8 and Rs 23.4, respectively.

Price catalyst

12-month price target: Rs 499 based on a PER methodology.

Catalyst: Initiatives in the products space or winning large deals (>USD 100 million) or acquisition to penetrate Europe/Japan.

Action and recommendation

We have cut our earnings forecast and revised our price target from Rs 673 to Rs 499. We downgrade Wipro to Neutral from Outperform, and we expect a negative surprise in the 1Q FY3/08 results. There are news reports that the company is looking at a major acquisition in Germany to expand its business in Europe’s largest economy. This may pose an upside risk to our recommendation.



TCS an outperformer; target Rs 1399

Event

Using our proprietary margin analysis framework, we conclude that for FY08 there will be an EBITDA margin erosion of 261bps for Tata Consultancy Services (TCS). However, we believe TCS can adjust to the new paradigm thanks to diversification of its delivery base in near-shore locations like Latin America and Eastern Europe, initiatives in the products business, and inorganic growth potential. We maintain our Outperform rating on the stock, but cut our FY08 EPS forecast by 13%.

Impact

Our proprietary margin analysis quantified the effect of ‘sorrow’ factors like a stronger rupee regime (Macquarie: FY08E Rs 40.3 per USD) and wage inflation, and ‘joy’ factors like pricing power and various productivity gain levers. WTCS started the current financial year with USD 1.1billion of currency forwards and options. This, coupled with 42% of natural hedging provided by its foreign exchange expenses and investments, is enough to shield margins until July 2007. Our calculations suggest that the realised foreign exchange rate for TCS will be Rs 41.4 per USD in FY3/08. The adverse impact of Re appreciation will result in a lowering of its EBITDA margin by 351bps in FY3/08. An increase in onsite wages (4%) and offshore wages (15%) will have a further negative impact of 399bps. The good news is the positive impact of levers like pricing (122bps), productivity gains (88bps), further offshore movement of work (17bps), an increase in utilisation (18bps) and SG&A leverage (244bps).

Earnings revision

Primarily due to the adverse exchange rate movement, our FY3/08E and FY3/09E EPS have been cut from Rs 54.7and Rs 73.1, to Rs 47.8 and Rs 62.9, respectively.

Price catalyst

12-month price target: Rs 1399 based on a PER methodology.

Catalyst: US listing or an acquisition to penetrate Europe/Japan, or some large deal wins (>USD 100 million).

Action and recommendation

We have cut our earnings forecasts and revised our price target from Rs 1654 to Rs 1399. We maintain our Outperform rating on the stock, with 22% upside from the current level. In the short term, there could be some weakness as TCS may guide for slow EPS growth for FY3/08. However, for long-term investors, the stock remains attractive in our view.



Infosys an outperformer; target of Rs 2437

Event

Using our proprietary margin analysis framework, we conclude that for FY08 there will be an EBITDA margin erosion of 210 bps for Infosys. However, we believe Infosys can adjust to the new paradigm thanks to its pricing power, initiatives in the products business and inorganic growth potential. Despite cutting our FY08 EPS forecast by 8.1%, we maintain our Outperform rating on the stock.

Impact

In our proprietary margin analysis, we quantified the effect of ‘sorrow’ factors like a stronger rupee regime (Macquarie’s forecast for FY08 is Rs 40.3/USD) and wage inflation, and ‘joy’ factors like pricing power and various productivity gain levers. Infosys has USD 1billion of hedging on its books. Based on the natural hedge available to the company and our economics team’s exchange rate forecasts, our calculations suggest that the realised Re rate for Infosys in FY3/08 will be Rs 41.6 per USD. Rupee appreciation will shave off 335bps from the EBITDA margin in FY3/08. Meanwhile, rising wages will dent this by a further 377bps. We have assumed a 15% rise in offshore wages and 4% increase in onsite wages. The above negatives will be partially offset by levers like pricing (147bps), productivity gains (77bps), further offshore movement of work (25bps), an increase in utilisation (37bps) and SG&A leverage (217bps).

Earnings revision

Because of adverse exchange rate movement, our FY3/08E EPS has been cut from Rs 83.7 to Rs 76.9, and our FY3/09E EPS been lowered from Rs 113.4 to Rs 103.9.

Price catalyst

12-month price target: Rs 2,437.00 based on a DCF methodology. Catalyst: Winning a couple of greater than USD 100 million deals or acquisition around Europe/Japan penetration.

Action and recommendation

We have cut our earnings forecasts marginally and revised our price target from Rs 2,671 to Rs 2,437. We maintain our Outperform rating on the stock, with 25% upside from the current level. In the short term, there could be some share price weakness as Infosys may cut its guidance for FY3/08 when announcing 1Q FY3/08 results in the second week of July. However, for long-term investors, it remains an attractive pick in our view.