>INDIA COMPUTER SERVICES (MERRILL LYNCH)

Irrational stock exuberance, in our view

■ Reiterate U/P view on IT; valuation-led 25% downside expected for Infy
Software stocks have rallied sharply and consensus is now positive. We reiterate our 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, we 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, we expect slower revenue growth going ahead on slower expansion of addressable market and greater competitive intensity. We have U/perform ratings on the top four Indian IT stocks, and we see the highest valuation-led downside for Infosys of ~25%. Our FY11e Infosys EPS is 8% below consensus.

■ Why do we expect FY11 margins to disappoint consensus expectations?
We differ from consensus and believe FY11 margins will decline not only because we expect 5% Re/USD appreciation next year but because a) we 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.

■ Structurally, believe revenue growth will be slower ahead
We also believe market will be disappointed with the revenue growth trajectory. 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 we 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.

■ Estimates & PO revised but valuations stretched
Faster than expected macro recovery and better vendor cost control lead us to raise estimates by 3-12% over FY10/11/12 for the large caps (Table 1). We also re-rate the stocks on increased revenue visibility & productivity improvements, raising POs by 20-60%. However, in our view valuations are stretched. Infy is trading at its highest PE in the last two years, at 22x 1yr fwd PE vs 3yr avg of 19x, while in fact we expect stocks to de-rate structurally, given a slower growth trajectory. Further, it is at an EV/E to 2-yr fwd EBITDA growth of 2x today vs 0.75x and 1.2x in Jan08, including FY09 actual and taking analyst estimates at the time

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