Dalal Street Investments

BOA Merrill – Sell IT Stocks Pull them Down

October 7, 2009

BOFA_Merrill Lynch which had already told that Tech sector will be under performer yesterday, has come out with a SELL on Indian IT Sector.

Why does BOA-Merrill Lynch expect FY11 margins to disappoint consensus
expectations ?

They differ from consensus and believe FY11 margins will decline not only because we expect 5% Re/USD appreciation next year but because a) expect wages will recover earlier than pricing and utilization in vendors like Wipro, HCL Tech and Patni is at a peak and b) discretionary S&M costs will pick up as vendors invest in developing new markets. Non-traditional markets like BPO/infrastructure services are likely to form 80% of incremental addressable market, as per NASSCOM.

Infy revenues (as proxy for sector) are highly correlated with S&P500 revenues, which have seen a much steeper fall and are forecast to recover more slowly as well, compared to 2003. Further, we expect slower revenue growth going ahead as they forecast that growth in addressable market is likely to halve over the next decade to 10% CAGR, compared to 2000-08 and market share gains are likely to be more gradual as competitive pressure grows.

Software stocks have rallied sharply and consensus is now positive. Reiterate Underperform view and believe the market will be disappointed in the near term,on margins and in the longer term on revenue growth trajectory. Unlike consensus, they expect margins to decline in FY11, not only due to Rupee appreciation but due to likely rise in wages, ahead of pricing recovery and a pick up in discretionary S&M costs. Structurally, they expect slower revenue growth going ahead on slower expansion of addressable market and greater competitive intensity. BOA-ML has U/perform ratings on the top four Indian IT stocks, and see the highest valuation-led downside for Infosys of ~25%. Our FY11e Infosys EPS is 8% below consensus.


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