>INDIAN IT SERVICES: Take a Breather — Positives Priced in? (CITI)

 Moderating our bullish thesis — Following strong outperformance (~45% outperformance in two years), relatively full valuations and multiple changes in the IT landscape, we are toning down our optimism. The sector trades at ~18.5x 1-yr forward – last time it traded at that level was when the top four companies were growing at ~25% (vs now at ~10-15%). Reverse DCF suggests ~11-19% 10-year implied EBIT CAGR. We downgrade Infosys to Neutral & TechM/Mindtree to Sells.

 Macro uplift not fully translating to revenue acceleration… — Top 5 cos grew 13.4% yoy in Q1FY15 vs 14.2% yoy in Q1FY14. This could be due to the changing IT services landscape and some impact of the law of large numbers – (a) commoditization in some of the traditional service lines; (b) high market share in the applications business, particularly in US; (c) cloud/SaaS impacting enterprise solutions segment. Longer-term impact of cloud remains something to watch out for.

 …Though medium-term growth drivers remain — The industry can still grow at low double digits: (a) new markets like continental Europe offer growth opportunities (Europe Opportunity – The 'New Normal'); (b) newer technologies (analytics, mobility etc.) can become significant in the medium term; (c) penetration is still low in the relatively new services lines (including BPO/ITO); (d) better capital allocation can support growth/multiples (M&A, Capital Return the Next Potential Catalysts).

 Downgrade Infosys, TechM, Mindtree — Infosys has had a good ~15% return (10% outperformance) in the past 3m, factoring in management change and cost improvements. We see risks of volatility ahead. Tech Mahindra – expect EBITDA growth of ~5% in FY15 – difficult to justify the premium to HCLT; downgrade to Sell. Mindtree remains the best-placed mid-cap – however, the sharp rerating (valuations at ~17x 1-yr forward vs ~11x 1 year back) may be running ahead of fundamentals.

 Absolute vs relative — Our investor interactions suggest that most investors struggle with the “absolute vs relative” call given the sharp rally in the Indian markets and valuations in some sectors being even higher. While that (as well as the depreciating INR) could help the sector in the near term, the industry issues should dominate over the medium term and, given where valuations are, we would
prefer to be more stock specific – HCLT/Wipro remain Buys.