The highflying share prices of Indian IT services firms soared in 2006, but signs of overly rich valuations have some investors tempering their enthusiasm in the new year. Corporate customers have flocked to offshore firms such as Cognizant Technology Services ( CTSH), Infosys Technologies ( INFY), Satyam Computer Services ( SAY) and Wipro ( WIT) for their reputation for quality work at cheaper prices, and investors, salivating over the impressive growth rates, have followed. In 2006, shares of Cognizant rose 52.3%, Infosys climbed 37.6%, Satyam shares tacked on 28.9%, and Wipro added 31.3%. In comparison, the S&P 500 rose 11.8% for the year. Observers generally remain bullish on the sector -- and they say the secular growth rate should remain intact over the long term. But starting the year, investors might want to take profits and wait for a better re-entry point. "I think the valuations are full, to say the least," says Standard & Poor's analyst Dylan Cathers. Based on his calendar 2007 estimates, Cognizant is selling for nearly 38 times earnings and both Infosys and Wipro are selling at over 30 times their earnings. Cathers has a hold rating on Cognizant, Satyam and Wipro and a sell on Infosys. He does not own shares, and his firm does not do banking. "I'm probably the only person on the planet with a sell on Infosys, but the valuations are very high," he adds.
He's waiting until the companies report their latest quarterly results -- starting with Infosys on Thursday -- for a possible correction or stumble that could make the stocks more attractive. Others agree that it's a good time to stay on the sidelines. "At the highest level, we definitely feel ... the seasonal trading patterns we have seen for the last five years do suggest some caution," Goldman Sachs analyst Julio Quinteros says. "You see a pretty good pullback in the first quarter." Though a few Indian firms remain on Quinteros' buy list, including Cognizant and the local shares of Satyam, he downgraded the Indian IT services sector to neutral on Wednesday, citing "low 'excess returns,' less compelling valuation, seasonally weak early-quarter performance and a muted IT spending environment." Goldman Sachs has received compensation from Infosys for investment banking and other services. Rising wages -- which are typically awarded in the new fiscal year, which begins in April, Quinteros says -- and continued
high rates of employee turnover are also prompting caution with some analysts. In its most recent quarter, employee attrition at Cognizant spiked to 20% from 15% in the prior period, and 11% in the quarter before. R.W. Baird analyst Sandra Notardonato lowered her rating of Cognizant citing risk from high turnover, and Nicolas De Smet of HSBC Global Research also slashed his rating from overweight to underweight, noting that "we are concerned about the capacity for Cognizant to recruit enough staff to sustain its current valuation."
Baird makes a market in Cognizant. HSBC does not have a financial relationship with the company. Even those who are more bullish on the Indian firms see some signs of slowing. Gilford Securities analyst Ashish Thadhani noted in a roundup of Indian firms that in the near term, with the 30% to 40% advance over 12 months, "returns are unlikely to approach these levels given valuation at the top-3 players
Infosys, Wipro and Cognizant of 36-44x forward EPS -- and limited room for EPS upside after 3% quarter-to-date rupee appreciation plus continuing wage pressures." "Additionally, the sector is susceptible to Sensex the Indian stock market volatility arising from valuation concerns and signs of an overheating economy," he noted. He has buy ratings on all four stocks, and his firm seeks to do banking with the companies it covers. But over the long term, most observers with Indian names in their portfolio remain optimistic. "Even though they've had great runs, we see no reason to sell the stock because the growth drivers are still intact," says Michael Binger, portfolio manager at Thrivent Asset Management, which holds shares of Cognizant and Infosys. Binger expects the 30% or more growth in earnings per share for both companies. "Their only concern is finding enough people," he says. "I don't think it's enough to override the fact that there's so much business out there for these guys to take on."
"Overall demand is quite good," says Rich Parower, a portfolio manger with J&W Seligman, which owns Satyam shares. "Customers are getting more comfortable with the kind of services these companies can provide. There's still tons of opportunity in Europe." Indian firms are diversifying their services beyond traditional IT, such as business process outsourcing, software testing services, application implementation and infrastructure outsourcing. Ram Mynampati, president of Satyam, said recently that engineering services is another area the company is developing, pointing out that it's the next logical extension of its services. "We don't need to sell India any longer," Mynampati said in an interview. "We believe that the same factors that helped us mature on the IT services side will also help us create a new market in R&D, and innovation," he said. For investors in Indian shares, "we still feel like there's lots of headroom left," Parower says.