Technology

Monthly
MONTHLY UPDATE SEPTEMBER 10, 2013

The Hedging Conundrum

Given the sharp INR depreciation, Indian IT services firms have begun to rethink their hedging strategies. Our analysis and conversations with management teams indicate a reluctance to enter into longer-term contracts and preference towards forward contracts over options. We also highlight the differences in accounting policies of our IT coverage universe. Our post-mortem analysis of HCL Techs higher-than-industryaverage revenue productivity indicates that the primary underlying reasons are its non-linear revenues in RIM and its business mix. Finally, we analyse the reasons for HCL Techs structurally higher current liability days (than its peers) and highlight the one-off items that led to the significant QoQ and YoY increase. Dissecting the hedging policies Whilst Infosys accounts for all hedging gains/losses in its P&L, HCL Tech, TCS and Wipro distribute the gains/losses across the P&L and the balance sheet. Also, Wipro and HCL Tech recognise the gains/losses on maturity of the effective cash flow hedges in revenues vs the industry practice of recognising it in other income. Forwards are the preferred hedging tools, with the exception of TCS which uses a mix of forwards and options. Initial evidences of changing hedging strategies With significant currency volatility, we find CFOs reluctant to enter into longerduration contracts and prefer forwards over options. An analysis of the reported hedging data indicates that whilst eClerx has increased the tenure as well as quantum of its hedge book, HCL Tech appears to be increasing the mix of forwards in its hedge book. Finally, hedges are likely to mature at 59 in 2Q. Delving deeper into employee productivity Although HCL Techs EBIT margins are below its tier-1 peers average, its profitability per technical employee is the best in the industry. Our analysis indicates that the secret lies in HCL Techs best-in-class employee productivity, arising from: (1) ~40% non-linear revenues in its IMS service line, (2) lower proportion of BPO and emerging market revenues, and (3) higher EAS employee productivity that is onsite heavy with lower maintenance revenues. Explaining HCL Techs structurally higher current liabilities HCL Techs higher-than-industry-average current liabilities primarily arise from: (1) unfunded gratuity plan vs funded gratuity plan for its peers, (2) bonus accruals over 3Q/4Q, (3) higher outsourcing costs, (4) larger proportion of projects under transition phase, and (5) lease equalisation (for operating leases). It also benefitted from one offs extended vendor credit and delayed invoice processing.
Valuation summary
Company TCS Infosys Wipro HCL Tech Polaris Persistent eClerx Reco BUY SELL SELL BUY SELL BUY BUY Mcap 26,661 59,665 17,700 10,866 179 348 381 CMP 3,021 1,980 468 1,013 117 570 826 TP 2,582 1,986 430 1,209 109 677 1,082 FY14 EPS 190.7 101.0 31.9 86.9 25.9 61.2 95.9 FY14 PE 15.5 17.0 13.9 10.2 3.9 9.1 7.9 FY14 EV/EBITDA 11.0 13.0 10.1 7.0 2.7 1.1 5.2

Recommendations
HCL Tech Target Price: 1,207 TCS Target Price: 1,986 Wipro Target Price: 430 Infosys Target Price: 2,581 eClerx Target Price: 1,082 Persistent Target Price: 677 Polaris Target Price: 109 BUY Upside : 19% BUY Upside : 0% SELL Upside : -8% SELL Upside : -15% BUY Upside : 31% BUY Upside : 19% SELL Upside : -7%

Analyst Details
Ankur Rudra, CFA +91 22 3043 3211 ankurrudra@ambitcapital.com Nitin Jain +91 22 3043 3291 nitinjain@ambitcapital.com

Source: Bloomberg, Ambit Capital research

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Technology

The Hedging Conundrum

The INR/USD rate depreciated by ~19% in a short period of five months, and thus, the volatile exchange rate has become a cause for concern for the CFOs of the Indian IT services industry. Our discussions with the company managements and analysis of the reported data broadly indicate that forward contracts are replacing options (where premiums have sky-rocketed) but managements prefer short-term contracts as a matter of conservatism. eClerxs management is, however, following a contrary strategy by increasing the hedge tenure as well as the hedge coverage. Infosys data too suggests a slight increase in longer duration contracts (>3 months); however, the average contract duration remains low (~5 months). HCL Tech has been increasing the use of forward contracts. In the sections to follow, we compare the hedging and hedge accounting policies across our coverage universe.

Taking a closer look at hedging policies

Exhibit 1: Hedging policies across our coverage universe
Company TCS Infosys Wipro HCL Tech Persistent Source: Ambit Capital research Hedging policy Mix of forwards and options (layered options). TCS hedges 12 quarters of revenues on a rolling basis. Short-term hedging policy, covering net open exposure in the next two quarters. Hedges 50% inflows for the next 12 months; predominantly forwards. The cash flow hedge covers 40% of likely inflows in less than one year and 25% of likely inflows after one year. Hedging 40-60% of net open foreign currency positions (i.e. net of natural hedge) on a 12-month rolling basis. This is done through plain-vanilla forward contracts.

Traditional users of forward contracts TCS emerges as an outlier

Although the hedging strategies differ across firms, most of the Indian IT services firms have traditionally used forward contracts to hedge their receivables. TCS is the only exception among the tier-1 firms, with an equal proportion of options and forwards in its hedge book. Whilst forward contracts provide true hedging (effectively locking the rate), options (particularly put options) provide only downside protection. However, this comes at a cost. Our discussions with the company managements suggest that companies tend to be reluctant to use options, given the associated upfront costs associated with options.

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Exhibit 2: Forward contracts dominate the hedging book of IT firms (as on June 2013)

Source: Company, Ambit Capital research estimates; Note: Wipro also uses predominantly forward contracts for hedging (the exact proportion is not reported by the company)

With the high volatility in the INR/USD rate over the last few weeks, options have become less cost-effective for the companies to hedge. On the other hand, increasing forward premiums are providing opportunities to the companies to get attractive forward rates. The increase in limits to cancel and re-book the forward contracts by exporters from 25% to 50%1 will provide a further fillip to the use of forward contracts by the companies.
Exhibit 3: Increasing forward premium makes forwards an attractive hedging tool Exhibit 4: High volatility in INR/USD leading to expansion in option premiums

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

Hedge accounting Infosys appears to be the most conservative

A look at the hedge accounting practices of Indian IT firms indicates that all the IT firms (except Infosys) classify their hedges into cash flow (designated) and nondesignated hedges. Whilst designated hedges are taken against the expected cash flows (i.e. revenues - with one-on-one mapping), non-designated hedges are taken against a pool of receivables without one-on-one mapping. The accounting treatment also differs the MTM gains and losses on the effective portion of the designated hedges are booked in the balance sheet whereas those on the ineffective portion are recognised in the P&L. All the MTM gains/losses on non-designated hedges are booked in the P&L.

http://economictimes.indiatimes.com/news/economy/policy/exporters-can-re-book50-of-cancelled-forwards-rbi/articleshow/22296602.cms
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Technology Among the companies under our coverage, whilst eClerx and Persistent recognise forward contracts as cash flow hedges and classify them as effective, HCL Tech, TCS and Wipro classify their hedges into designated and non-designated and also bifurcate their designated hedges into effective and non-effective. TCS and Wipro classify ~57% and ~47% of their receivable related hedges (i.e. excluding the hedges relating to the borrowings) as cash flow hedges.

Wipro and HCL Tech partly make P&L adjustment in the top-line; Infosys and TCS show the entire amount below EBITDA
The accounting methods for the hedging-related gains/losses in the P&L account are notably different across firms. Companies such as TCS, Infosys, Persistent Systems, eClerx and Polaris show the hedging gains/losses as a part of other income. On the other hand, HCL Tech and Wipro account for gain/loss on completion of the effective cash flow contracts as a part of revenues. Although both the methods are legitimate from an accounting point of view, it creates inconsistency during margin comparison among peers. The EBIT/EBITDA margins are overstated in case of hedging gain and understated in case of hedging losses under the methods followed by HCL Tech and Wipro. The hypothetical analysis in Exhibit 5 illustrates this point.
Exhibit 5: Margin impact analysis under methods of accounting hedging losses in P&L (Rs mn)
Base case (cash flow hedging gains/losses booked as other income) 10,000 2,000 20% 100 Cash flow hedging Cash flow hedging loss gain of 100 adjusted of 100 adjusted in revenues in revenues 10,100 9,900 2,100 1,900 21% 19%

Revenue EBIT EBIT margin Forex adjustment Source: Bloomberg

Foreign currency borrowing additional source of forex risk for Wipro

Wipro has external commercial borrowings of US$150mn, for which it has an interest rate swap agreement of US$150mn.

CFOs hedging dilemma

Significant volatility in the INR/USD rate over the last one month has increased the uncertainties associated with hedging. Our conversations with company CFOs indicate three broad trends:

Companies are reluctant to enter into longer-term contracts (though eClerx is an

exception). Companies are opting to remain at the lower end of the board-approved hedging cover range (hedging implies the forward 12-month revenue covered by hedging). High premiums are making options unattractive; companies are increasingly using forward contracts.

The change in hedging strategies is evident from eClerxs and HCL Techs reported metrics. eClerx has increased its hedging exposure both in duration as well as quantum (eClerx increased the amount of its hedge book from ~65% of TTM revenues in FY13 to 81% in 1QFY14). Further, it increased the proportion of longterm hedges (>1 year duration) from 23% in March 2013 to 33% in June 2013. The strategy adopted by eClerx is somewhat contrary to the views heard from other company managements. HCL Tech, on the other hand, has increased the proportion

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Technology of forward contracts in its hedge book. Exhibits 6 to 11 below display the changing trends in hedging strategies.
Exhibit 6: TCS Stable hedging trends; not much movement in use of forwards and hedging coverage Exhibit 7: Infosys slight uptick in use of longer-term hedging contracts

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 8: Wipro Slight decline in hedging coverage; management indicates no change in strategy

Exhibit 9: HCL Tech growing percentage of forward contracts hedge book; slight increase in long-term hedges

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 10: Persistent Systems Some uptick in hedging coverage; management indicates no change in strategy

Exhibit 11: eClerx Increasing hedge coverage; hedging continues to be driven by forward contracts

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

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Technology

Average hedging rates at ~Rs59 levels; may lead to deterioration in cash conversion
Among the companies that share the hedge booking rate data (HCL Tech, Persistent Systems and eClerx), we observe that the average booking rate has been ~Rs59. Given the significant depreciation in INR over the last one month, the average exchange rate for the quarter could be ~Rs63 (assuming INR stays at the current levels for the rest of the quarter). Given that the hedges expiring during the September 2013 quarter would have been below the average Rs59 level, this would imply lower realisation. As revenues and expenses (and hence EBITDA) would be converted at the average exchange rate of ~Rs63 whilst realisation would be lower due to lower hedge booking rates, the cash conversion (CFO/EBITDA) might come under pressure in 2QFY14. Furthermore, the 11.5% depreciation in INR since the end of the last quarter would imply MTM hedging losses. The quantification of the hedging losses is not possible as the granular details on cash flow - effective and non-effective and non-designated hedges - are not shared by the companies, which makes it difficult to determine the extent of the impact on the P&L and balance sheet. Further, these hedging losses/gains would be offset to some extent by revaluation in net monetary assets.

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Technology

Employee Productivity Analysis

Although HCL Techs EBIT margins, at 21%, are at the lower end of the industrys margin range (23% average for tier-1 peers for the quarter-ending June 2013), HCL Techs profitability per technical employee is the best in the industry i.e. ~7% above TCS (the company with the best EBIT margins) and ~8% above Infosys (the next best EBIT margins after TCS). This has been a subject of constant debate among investors and has raised questions over the companys secret behind achieving this. Our analysis indicates that the secret lies in HCL Techs best-in-class employee productivity (revenue per billed employee), which more than offsets its lower EBIT margins. HCL Techs employee productivity, adjusting for sub-contractors, is 34% above its tier-1 peers average. However, adjusting for utilisation, HCL Techs revenue productivity is 21% above the average. Similarly, per employee productivity adjusted for utilisation is 5% above Infosys, which still charges a premium for services.
Exhibit 12: Employee productivity adjusting for subcontractors

Source: Company, Ambit Capital research estimates

RIM is the largest source of high employee productivity: According to the

managements estimates, ~40% of HCL Techs revenues in this service line are non-linear (i.e. de-linked from headcount), largely reflecting the higher proportion of managed service deals and industrialisation initiatives by the management. RIM accounts for ~31.5% of HCL Techs consolidated revenues. proportion of blue-printing and implementation business in EAS, lower proportion of BPO in the business mix and the least exposure to lower-realisation emerging geographies are the additional factors contributing to better-than-peer employee productivity.

Business mix also explains the divergence: Furthermore, the higher

Gauging the impact of business mix variance on productivity

Exhibits 13 to 16 below compare the revenue productivity of tier -1 firms adjusted for subcontractors, onsite business, EAS and BPO, because a different mix of these services affects overall employee productivity. Our analysis indicates that even after excluding the revenues from BPO and EAS and billed employees from the equation, HCL Techs employee productivity is 9% higher than its tier-1 peers average.

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Technology This largely reflects significantly higher employee productivity in the RIM business, arising from a higher non-linear component (which is also reflected in the higher proportion of fixed-price contracts) as indicated by the management and low presence in emerging geographies. Note that HCL Tech has the highest effort mix of Core software services (excluding EAS) among the tier-1 firms (see Exhibit 20). Its significantly better-than-peer employee productivity in Core Software Services (excluding EAS) has a positive effect on overall business employee productivity.
Exhibit 13: Revenue productivity adjusted for onsite revenues (adjusted for subcontractors and utilisation) Exhibit 14: Revenue productivity adjusted for EAS (adjusted for subcontractors and utilisation)

Source: Company, Ambit Capital research estimates

Source: Company, Ambit Capital research estimates

Exhibit 15: Revenue productivity adjusted for BPO (adjusted for subcontractors and utilisation)

Exhibit 16: Revenue productivity adjusted for EAS and BPO (adjusted for subcontractors and utilisation)

Source: Company, Ambit Capital research estimates

Source: Company, Ambit Capital research estimates

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Technology

Exhibit 17: HCL Tech has the lowest presence in Emerging geographies

Exhibit 18: HCL Tech has the highest proportion of fixedprice contracts in the revenue mix

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 19: HCL Techs EAS employee productivity is the best the industry thanks to higher proportion of Blue-printing and Implementation work

Exhibit 20: HCL Tech has the highest proportion of efforts in its Core Software Services business (excl EAS), where it enjoys higher productivity led by the RIM business

Source: Company, Ambit Capital research

Source: Company, Ambit Capital research

Exhibit 21: Despite lower EBIT margins, HCL Techs per employee productivity is the bes industry, thanks to best-in-class employee productivity
For the quarter-ending June EBIT margin EBIT per billed employee EBIT per technical employee Source: Company, Ambit Capital research TCS 27.0% 17,222 12,592 Infosys 23.6% 17,329 12,438 Wipro 20.0% 13,360 8,657 HCL Tech 21.0% 16,245 13,422

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Technology

Key assumptions used for the analysis

To calculate revenue productivity, we have adjusted the denominator for
utilisation and also included the estimated sub-contracted employees. Hence, our analysis calculates revenue productivity per billed employee (including the subcontractors). Note that we have used the reported utilisation metrics of the companies. Firms have different definitions of utilisation; e.g. Infosys excludes employee leaves from utilisation whilst TCS, Wipro and HCL Tech include employee leaves. This may create certain inconsistencies in our analysis. offshore), EAS (onsite and offshore) and BPO and calculated the weighted average based on the billed efforts in these businesses to arrive at the consolidated employee productivity.

We have decomposed the employee productivity into IT outsourcing (onsite and

All the sub-contractor headcount is adjusted in the onsite non-EAS IT services

headcount, except for Wipro and HCL Tech. Wipro reports headcount as well as efforts including sub-contractors whilst HCL Tech reports effort mix in its core software business including sub-contractors.

For all the companies except HCL Tech and Wipro, we assume Onsite revenue

mix in the EAS business to be the same as the reported number for the overall business. For HCL Tech, we have assumed onsite:offshore revenue mix of 75:25 and for Wipro we assume 65:35. 2.1x for Infosys and Wipro and 2.6x for HCL Tech.

EAS per employee productivity as a multiple of Core IT services for TCS is 2x vs

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Technology

Digging deeper into HCL Techs current liabilities

HCL Techs US GAAP current liability days (including unearned revenues) increased by 12 days QoQ and 14 days YoY in 4QFY13 (quarter-ending June 2013), raising concerns over the sustainability of such an increase. Whilst the QoQ increase in current liabilities was due to accruals for bonuses (which are paid over the September and December quarters), our conversation with HCL Techs management indicates that two extraordinary items led to the sharp YoY increase in current liabilities and also improved CFO: 1. Vendor credit of ~US$61.5mn for certain operating expenses; and 2. Postponement of vendor payments due to delay in installing new automated vendor invoice processing system (not quantifiable in the absence of details). Adjusting for the vendor credit (the only quantifiable item), the current liability days increased by 6 days QoQ and 9 days YoY, as elaborated in Exhibit 22 below. Similarly, the cash conversion ratio (CFO/EBITDA) was overstated due to these adjustments. Removing the above-mentioned two one-off items, the 4QFY14 cash conversion would have been 109% vs 117% reported (as elaborated in Exhibit 22 below). Note that with further adjustment of the postponed vendor payments, the increase in current liability days and the cash conversion days would have been lower. Nonetheless, the management expects the vendor credit arrangement to sustain, implying that the benefits may not reverse in FY14.
Exhibit 22: Current liability days (including unearned revenues and excluding short-term borrowings and financial derivative liabilities) HCL Tech
In US$ mn EBITDA CFO Current liabilities Adjustments Vendor credit from capex Delayed payments due to installation of automated vendor invoice processing system Derivative related losses (included in Current liabilities) Adjusted Current liabilities Adjusted Current liability days Reported Current liability days Adjusted CFO Adjusted CFO/EBITDA CFO/EBITDA 0 NA 0 NA 0 NA 0 NA 0 NA 0 NA 0 NA 0 NA 0 NA 13* NA 13* NA 13* NA 24# NA 1QFY11 1QFY11 2QFY11 3QFY11 4QFY11 1QFY12 2QFY12 3QFY12 4QFY12 1QFY13 2QFY13 3QFY13 4QFY13 137 133 675 131 10 691 141 80 730 158 118 765 178 173 755 171 26 720 189 132 742 193 103 770 237 248 888 247 70 830 261 251 861 267 177 957 288 336 1,102

NA NA NA 109 NA NA 97%

NA NA NA 103 NA NA 7%

NA NA NA 101 NA NA 57%

NA NA NA 98 NA NA 74%

NA NA NA 90 NA NA 97%

NA NA NA 82 NA NA 15%

NA NA NA 82 NA NA 70%

NA NA NA 82 NA NA 53%

39 849 89 93 NA NA 105%

NA 818 85 86 57 23% 28%

NA 836 85 88 238 91% 96%

NA 919 92 96 164 62% 66%

39# 1,001 98 107 313 109% 117%

Source: Company, Ambit Capital research; Note: * Our estimates, # Company estimates

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Exhibit 23: Cash conversion trend (CFO/EBITDA) HCL Tech vs peers
Jun10 Sep10 Dec10 Mar11 Jun11 Sep11 Dec11 Mar12 Jun12 Sep12 Dec12 Mar13 Jun13 TCS Cognizant Infosys Wipro Average HCL Tech HCL Tech (Adjusted) 45% 59% 79% 57% 60% 97% NA 61% 92% 68% 57% 70% 7% NA 82% 144% 69% 37% 83% 57% NA 56% 16% 50% 96% 54% 74% NA 52% 72% 78% 23% 56% 97% NA 41% 102% 84% 45% 68% 15% NA 50% 84% 73% 58% 66% 70% NA 61% 29% 69% 99% 65% 53% NA 59% 88% 72% 60% 70% 105% NA 63% 97% 86% 89% 84% 28% 23% 76% 91% 89% 101% 89% 96% 91% 73% 17% 82% 93% 66% 66% 62% 78% 80% 65% 117% 109% QoQ YoY 42% -3,151 -1,794 6,087 -1,017 -175 -144 5,050 4,690 781 25 -501 1,221 NA

60% -3,339

Source: Company, Ambit Capital research

Exhibit 24: Current liability days comparison for quarter-ending June 2013

Source: Company, Ambit Capital research * Adjusted for derivative financial instruments

That said, HCL Tech's current liabilities have been significantly above the peer average in the last two years (see Exhibits 25 and 26 below). This has contributed significantly to the CFO (e.g. increase in current liabilities contributed US$206mn to the CFO of US$834mn in FY13 and US$241mn contribution to the CFO of US$509mn in FY12).
Exhibit 25: Current liabilities (excluding borrowings and financial instruments) including short-term provisions (in days)
FY11 TCS Infosys Wipro Average HCL Tech* 72 74 105 84 86 FY12 67 73 97 79 96 FY13 67 78 105 83 NA TCS Infosys Wipro Average HCL Tech*

Exhibit 26: Current liabilities (excluding borrowings and financial instruments) (in days)
FY11 60 49 80 63 68 FY12 55 46 76 59 77 FY13 57 50 80 62 NA

Source: Company, Ambit Capital research; Note: * Year-ending June for HCL Tech

Source: Company, Ambit Capital research; Note: * Year-ending June for HCL Tech

The below factors explain HCL Techs structurally high current liabilities relative to its peers:

Bonus accruals in 4Q: HCL Tech creates accrued liability for Long Term

Incentive Plans (LTIPs) and bonuses over 3Q-4Q (quarter-ending June) and pays it over 1Q and 2Q every year. According to the FY12 Annual Report, this is a significant amount and was equivalent to 9.5/10.5 working capital days (2.6%/2.8% of revenues) in FY11/12. Among the tier-1 peers, whilst Infosys and Wipro have some element of bonus accruals in the quarterly balance sheet (not quantifiable due to absence of information), TCS does not have any balance
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Technology sheet bonus accruals. A direct comparison is not possible due to information asymmetry.

Unfunded gratuity plan: HCL Tech does not have a funded gratuity plan and it

manages the gratuity obligation on its own. This is booked as a part of short-term and long-term provisions. All of HCL Techs tier-1 peers have well-funded gratuity plans, implying a relatively lower amount in the current liabilities and provisions. them for the Infrastructure (RIM) business. Indeed, over 40% of the outsourcing costs (which in turn constitute ~12% of revenues) are non-manpower related. This is also one of the reasons for higher accrued expenses (accrued expenses constitute nearly one-third of HCL Tech's total operating current liabilities) as compared to its peers.

Higher outsourcing costs: HCL Tech does not own the data centres but leases

Hunting-led growth - higher proportion of projects under transition

phase: HCL Tech has largely relied on hunting-led growth over the past several quarters (also highlighted in our July issue of Technology Monthly Changing engines of growth). This also reflects in the comparatively lower revenues from the repeat business. The higher proportion of new client additions implies larger proportion of projects under the transition phase. According to the management, many times, the transition phase involves certain advance payments from the client.

Exhibit 27: Advances from customers (including unearned revenue days)

FY11 TCS Infosys Wipro Average HCL Tech Source: Company, Ambit Capital research 11 11 11 11 15 FY12 9 9 13 10 16 FY13 9 11 16 12 NA

Exhibit 28: Revenue growth decomposition (Mar08 Mar11)

Exhibit 29: Revenue growth decomposition (Mar11 Mar13)

Source: Company, Ambit Capital research; Note: * Comprising TCS, Cognizant, Infosys, Wipro and HCL Tech

Source: Company, Ambit Capital research Note: * Comprising TCS, Cognizant, Infosys, Wipro and HCL Tech

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Exhibit 30: HCL Techs revenue from repeat business is lower than the tier-1 peers

Source: Company, Ambit Capital research

Operating leases: HCL Tech has some operating leases that inflated its FY13
current liabilities by US$20mn due to lease equalisation. However, this should not impact the CFO since it is a non-cash item and hence effectively is CFOneutral. We do not know the absolute amount in FY12 and FY13 (not mentioned in the FY12 annual report).

Exhibit 31: HCL Techs current liabilities and provisions break-up (Rs mn)
FY11 Trade payable % of operating current liabilities and provisions Advance from customers and income received in advance % of operating current liabilities and provisions Employee benefit accruals % of operating current liabilities and provisions Accrued expenses % of operating current liabilities and provisions Taxes payable % of operating current liabilities and provisions Short-term provisions - For employee benefits % of operating current liabilities and provisions - For taxes % of operating current liabilities and provisions Long-term provisions - For employee benefits % of operating current liabilities and provisions Total operating current liabilities and provisions % of revenues Source: Company, Ambit Capital research 1,442 4% 32,628 21% 2,879 6% 49,311 24% 2,347 7% 4,282 13% 2,882 6% 7,269 15% 2,770 8% 5,540 17% 6,182 19% 8,237 25% 1,829 6% FY12 4,694 10% 7,515 15% 9,501 19% 12,256 25% 2,315 5%

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Technology

Sharp INR depreciation

Assuming the exchange rates remain at the current levels for the rest of the year, the USD vs INR and AUD is likely to appreciate by 12% and 9%, respectively, during FY14, whilst other currencies are likely to remain relatively flat. During the past one month, the USD has appreciated by 7.3% against the INR and by 1.4% against EUR whilst it has depreciated by 1.5% against GBP.
Exhibit 32: INR/USD exchange rate movement Exhibit 33: EUR/USD exchange rate movement

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

Exhibit 34: GBP/USD exchange rate movement

Exhibit 35: Estimated currency gains for FY14 over FY13*

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research; Note: * Assuming exchange rates remain at the current levels for the rest of the year.

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Market watch
Exhibit 36: Recent deal announcements
Company TCS HCL Tech Wipro TCS Wipro Deal announcement Client date 04/09/2013CTM, Macau 04/09/2013Direct Energy 03/09/2013Deutsche Bank 03/09/2013DNB Group US-based healthcare 29/08/2013 service company Vertical Telecom Energy and Utilities Financial Services Financial Services Healthcare Deal details It is a multi-year, multi-million-dollar IT and business transformation project, wherein TCS will provide a new convergent rating and billing system. It is an outcome-based deal, wherein HCL Tech will implement and manage Direct Energy's residential billing and customer care operations in the Alberta market. It will provide Infrastructure hosting, Application Management and Business Process Services. According to media articles, this is a five-year ~US$125mn contract to provide Application Maintenance services with elements of Application Development. It is a six-year Managed Services contract to provide Application Maintenance and Development services. It is a ~US$100mn Infrastructure Management contract involving consolidation of clients' multiple data centres.

Source: Company, Ambit Capital research

News from the street

More exits and leadership rejigs at Infosys (September 06, 2013) After the departures of three senior leaders (Basab Pradhan, Sudhir Chaturvedi and Ashok Vemuri), Infosyss Latin America head of BPO business, Humberto Andrade, has quit to join Capgemini. He has been replaced by an Infosys veteran, Aniket Maindarkar, who has re-joined after a short stint at Cognizant. As part of the leadership rejig, V Balakrishnan (Head of BPO, Lodestone, Finacle and India business) has been given additional responsibilities as head of the newly created Utilities and Resources division in North America. Chandrashekhar Kakal, who currently heads the Business IT Services, has been given additional responsibilities to head the Consulting and Systems Integration business. Stephen R Pratt, managing partner for Consulting and Systems Integration, will now manage the Utilities and Resources division and will report to V Balakrishnan. The mid-to-senior management exit is a typical feature of organisational restructuring, as seen at Wipro as well during its restructuring phase. However, the leadership rejig by Infosys appears to be a reactive measure to the recent exits and will take some time to settle down. Cognizant enters into partnership with autonomics firm, IPSoft (August 27, 2013) According to media articles2, Cognizant has entered into a partnership with autonomics firm, IPSoft, for its Infrastructure Management Services offerings. IPsoft and Cognizant will convert a data centre of Cognizant in the US into a centre of excellence for autonomics, and follow it up with two other such centres in Europe and India. Infosys also had entered into similar arrangements with IPSoft in April 2013. Wipro plans to add 500 people in the Nordic region (September 03, 2013) With a team of 500 people in the Nordic region already, Wipro is adding 500 more 500 people to strengthen its operations in this market. It has also appointed CarlHenrik Hallstrom as the Regional Head for the Nordic region. He will report to Rajat Mathur, Chief Sales and Operations Officer (Growth Markets) at Wipro. In his previous role, Hallstrom was associated with KPMG, Sweden.

http://articles.timesofindia.indiatimes.com/2013-08-27/software-services/41495763_1_traditionalautomation-tools-ipsoft-worldwide-indian-american-chetan-dube

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Technology Wipro partners with US firm Kana Software (September 07, 2013) With this partnership, Wipro will provide customer service solutions to its global insurers through a joint development centre. Kana provides customer service solutions using a cloud computing (on-demand) network. Polaris Company Secretary, B Muthusubramanian, resigns (September 02, 2013)

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Price performance
With continued news flow on improving demand sentiments in the US and sharp depreciation in INR against USD, IT services firms have materially outperformed the Sensex. Indeed, many of these firms are trading close to their 52-week highs. NIIT Tech and Polaris were the highest gainers in the last two weeks. After a strong run post the merger completion, Tech Mahindras share price declined by 1.4% in the last two weeks.
Exhibit 37: Share price performance
Company Sensex TCS Infosys Wipro HCL Tech Tech Mahindra Mphasis Hexaware Mindtree eClerx KPIT Persistent Polaris NIIT Tech Source: Bloomberg 5 Days chg 3.49% -2.18% -2.47% -3.12% -2.26% -1.07% -0.78% -2.42% -0.53% -0.91% 1.17% -3.24% -1.22% 3.81% 2 week chg 3.84% 7.97% -0.05% 2.05% 7.67% -1.40% 4.24% -2.46% 2.47% 4.82% 0.68% -0.60% 11.53% 13.36% 1 month chg 2.87% 6.35% 1.40% 3.81% 7.68% 10.29% 4.94% 5.26% 5.62% 7.29% 0.91% 10.77% -1.27% 18.28% 3 month chg -1.28% 35.22% 24.67% 41.97% 36.02% 47.06% -8.67% 51.88% 24.80% 19.23% 14.59% 7.83% -2.17% 12.23% 6 month chg 0.09% 27.39% 1.98% 18.87% 34.46% 26.00% 5.15% 43.27% 17.86% 30.87% 26.65% 0.47% -2.62% 7.27% 1 year change 11.09% 44.58% 25.06% 39.17% 78.87% 62.29% 8.31% -2.87% 47.57% 4.80% 3.05% 44.44% -3.58% 1.58% YTD chg -0.81% 58.36% 30.64% 33.15% 64.37% 45.92% 8.61% 46.89% 51.02% 20.47% 20.42% 10.95% 2.50% 20.80%

Exhibit 38: Share price performance over the last two weeks

Source: Bloomberg

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Relative valuation
At a consensus EPS CAGR of 13% over CY12-14E, HCL Tech looks attractive at the current CY13 P/E multiple of 12.1x among the tier-1 firms (at a ~20% discount to laggards, Wipro and Infosys), whilst TCS looks fairly valued. HCL Tech currently trades close to its five-year average forward P/E and EV/EBITDA multiple. Given the consistent margin and revenue performance and improving RoEs over the past few quarters, we expect potential upward re-pricing of shares. After a strong set of results and an optimistic guidance (after a prolonged underperformance), Wipro trades at a 16% premium to its five-year average forward P/E multiple whilst Infosys trades at a slight premium to its five-year average forward EV/NOPAT multiples. Among tier-2 stocks, high-quality names such as Persistent Systems and eClerx are trading close to their five-year average valuation multiples, whilst stocks such as Polaris (due to lack of traction in business and uncertainty over business structure) and Mphasis (due to lack of visibility in HP business) are trading at a significant discount to their historical average valuation multiples. Indeed, Persistent Systems is currently trading close to its lowest valuation multiples over the last five years. We remain strong BUYers on HCL Tech (19% upside) among the tier-1 firms and eClerx (32% upside) and Persistent Systems (19% upside) among the tier-2 firms.
Exhibit 39: Premium to five-year forward P/E Exhibit 40: Premium to five-year forward EV/NOPAT

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

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Exhibit 41: Forward P/E multiples relative to five-year average, high and low

Exhibit 42: Forward EV/EBITDA multiples to five-year average, high and low

Source: Bloomberg, Ambit Capital research

Source: Bloomberg, Ambit Capital research

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xxx

Exhibit 43: Indian IT Services - relative valuation as on 6 September 2013

Curr Indian peers (Large-sized cos) TCS Infosys Wipro HCL Tech Median Mean Indian peers (Mid-sized services) Tech Mahindra Mphasis Hexaware Mindtree eClerx KPIT Persistent Polaris Median Mean Global Tier 1 IT services IBM Accenture HP Cognizant BT CapGemini CSC Median Mean Global regional IT services Atos Syntel Median Mean Price MCap (Mn) INR INR INR INR 1,989 3,029 469 1,017 3,892,521 1,739,390 1,154,757 708,881 Div Yield CY13 1.3% 1.6% 1.6% 1.5% 1.5% 1.5% 0.6% 4.0% 4.3% 1.2% 3.5% 0.7% 1.7% 4.3% 2.6% 2.6% 1.9% 2.3% 2.6% 0.0% 0.4% 2.4% 1.6% 1.9% 1.6% 1.2% 3.4% 2.3% 2.3% Sales CAGR (CY12-14) 20% 15% 13% 16% 15% 16% 17% 12% 14% 16% 15% 19% 19% 12% 15% 15% 0% 2% -5% 18% 0% 1% 0% 0% 2% 1% 12% 6% 6% EV/SALES CY13 5.1 3.4 2.6 2.0 3.0 3.3 1.7 1.2 1.4 1.4 2.6 1.0 1.3 0.4 1.3 1.4 2.2 1.6 0.5 2.3 0.1 0.7 0.6 0.7 1.1 0.5 3.1 1.8 1.8 CY14 4.4 3.0 2.3 1.8 2.7 2.9 1.6 1.1 1.3 1.3 2.2 0.9 1.1 0.3 1.2 1.2 2.2 1.5 0.5 2.0 0.1 0.6 0.6 0.6 1.1 0.5 2.8 1.7 1.7 EBITDA CAGR (CY12-14) 20% 10% 14% 14% 14% 15% 14% 8% 14% 16% 13% 21% 15% 14% 14% 14% 8% 4% -2% 17% 1% 8% 1% 4% 5% 5% 11% 8% 8% EV/EBITDA CY13 17.6 12.4 12.4 9.2 12.4 12.9 8.3 6.7 6.7 7.4 6.6 6.2 5.2 2.8 6.6 6.2 8.2 9.4 3.9 11.1 4.2 6.6 4.0 6.6 6.8 4.8 9.8 7.3 7.3 CY14 15.2 11.2 11.0 8.1 11.1 11.4 7.9 5.9 6.0 6.6 5.8 5.5 4.6 2.5 5.9 5.6 7.6 9.2 3.9 9.6 4.2 6.2 4.0 6.2 6.4 4.5 9.1 6.8 6.8 NOPAT CAGR (CY12-14) 21.1% 10.2% 13.0% 13.3% 13% 14% 63.2% 9.1% 10.2% 18.0% 15.1% 23.6% 13.5% 6.8% 14% 20% 10.4% 8.0% -15.3% 18.9% 0.7% 3.7% 49.7% 8% 11% 11.9% 7.3% 10% 10% EV/NOPAT CY13 24.2 18.7 17.3 13.4 18.0 18.4 15.8 10.3 9.5 10.7 10.7 9.8 9.7 5.0 10.0 10.2 12.5 14.6 7.3 16.0 1.0 11.6 10.1 11.6 10.5 10.0 14.0 12.0 12.0 CY14 20.8 16.8 15.6 11.9 16.2 16.3 12.6 9.0 8.7 9.7 9.7 8.5 8.6 4.5 8.8 8.9 11.9 14.3 7.3 13.7 1.0 10.8 12.2 11.9 10.2 9.3 13.5 11.4 11.4 EPS CAGR (CY12-14) 20% 9% 13% 14% 14% 14% 9% 5% 10% 18% 15% 23% 15% 9% 12% 13% 10% 8% 106% 19% 0% 18% 8% 10% 24% 35% 7% 21% 21% P/E CY13 24.1 17.5 16.9 13.8 17.2 18.1 11.0 11.2 10.3 11.4 9.8 10.1 10.6 5.3 10.4 10.0 11.0 17.0 6.2 18.2 8.5 14.7 12.4 12.4 12.6 13.0 15.5 14.3 14.3 CY14 20.8 15.8 15.1 12.1 15.5 16.0 10.1 10.0 9.4 10.3 8.5 8.7 9.3 4.8 9.4 8.9 10.1 15.9 6.1 15.6 8.5 13.2 11.9 11.9 11.6 11.7 14.6 13.1 13.1 ROE CY13 37% 24% 23% 29% 26% 28% 27% 17% 28% 27% 42% 22% 20% 15% 24% 25% 91% 61% 26% 22% 67% 11% 17% 26% 42% 16% 25% 20% 20% CY14 34% 22% 22% 26% 24% 26% 24% 17% 27% 24% 38% 21% 19% 15% 22% 23% 84% 58% 22% 21% 67% 11% 17% 22% 40% 16% 17% 17% 17%

INR INR INR INR INR INR INR INR

1,360 418 125 1,031 825 134 568 117

316,016 87,728 37,409 42,868 24,824 25,824 22,732 11,648

USD USD USD USD USD EUR USD

184 74 22 76 24 44 51

201,723 50,842 42,660 22,904 1,368 6,931 7,482

EUR USD

57 74

4,901 3,090

Source: Bloomberg, Ambit Capital Research

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Exhibit 44: Ambit valuation summary
Infosys Price Recommendation Price target Upside/Downside Market Cap (US$ mn) ADVT - 3 months (US$ mn) EPS (Rs) FY13 FY14E FY15E EPS CAGR PE (x) FY14E FY15E EV/EBITDA (x) FY14E FY15E EV/NOPAT (x) FY14E FY15E ROE FY14E FY15E Source: Ambit Capital research, Company 25% 23% 47% 43% 25% 22% 37% 29% 17% 13% 22% 20% 57% 41% 16% 17% 19% 23% 16.91 16.72 19.84 18.15 15.18 14.15 6.28 6.11 9.97 11.83 8.83 8.17 8.21 8.97 9.88 8.29 31.87 21.80 10.95 10.75 13.02 11.77 10.09 9.30 7.05 6.80 2.71 3.06 1.05 0.97 5.20 5.54 6.67 5.54 19.99 14.20 15.52 14.75 17.01 14.93 13.86 12.54 10.19 9.65 3.92 4.50 9.12 8.23 7.93 8.67 7.42 5.71 27.06 19.28 165 191 201 10% 71 101 115 27% 25 32 35 19% 56 87 92 28% 20 26 23 6% 46 61 68 21% 57 96 88 24% 8 8 10 11% 8 11 16 38% 3,021 SELL 2,582 -15% 26,661 49.0 TCS 1,980 BUY 1,986 0% 59,665 39.5 Wipro 468 SELL 430 -8% 17,700 14.6 HCL 1,013 BUY 1,209 19% 10,866 17.6 Polaris Persistent 117 SELL 109 -7% 179 1.9 570 BUY 677 19% 348 0.3 eClerx Redington 826 BUY 1,082 31% 381 0.3 57 BUY 81 42% 350 0.3 InfoEdge 295 BUY 396 34% 493 0.7

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Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities Research Analysts Aadesh Mehta Achint Bhagat Ankur Rudra, CFA Ashvin Shetty Bhargav Buddhadev Dayanand Mittal Gaurav Mehta Karan Khanna Krishnan ASV Nitin Bhasin Nitin Jain Pankaj Agarwal, CFA Pratik Singhania Parita Ashar Rakshit Ranjan, CFA Ravi Singh Ritika Mankar Mukherjee Ritu Modi Shariq Merchant Tanuj Mukhija Utsav Mehta Sales Name Deepak Sawhney Dharmen Shah Dipti Mehta Nityam Shah, CFA Parees Purohit, CFA Praveena Pattabiraman Sarojini Ramachandran Production Sajid Merchant Joel Pereira
E&C = Engineering & Construction

(022) 30433174

saurabhmukherjea@ambitcapital.com

Industry Sectors Banking / NBFCs Cement / Infrastructure Technology / Telecom / Media Automobile Power / Capital Goods Oil & Gas Strategy / Derivatives Research Strategy Banking E&C / Infrastructure / Cement Technology NBFCs Real Estate / Retail Metals & Mining Consumer / Real Estate Banking / NBFCs Economy / Strategy Healthcare Consumer E&C / Infrastructure Telecom / Media

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E-mail aadeshmehta@ambitcapital.com achintbhagat@ambitcapital.com ankurrudra@ambitcapital.com ashvinshetty@ambitcapital.com bhargavbuddhadev@ambitcapital.com dayanandmittal@ambitcapital.com gauravmehta@ambitcapital.com karankhanna@ambitcapital.com vkrishnan@ambitcapital.com nitinbhasin@ambitcapital.com nitinjain@ambitcapital.com pankajagarwal@ambitcapital.com pratiksinghania@ambitcapital.com paritaashar@ambitcapital.com rakshitranjan@ambitcapital.com ravisingh@ambitcapital.com ritikamankar@ambitcapital.com ritumodi@ambitcapital.com shariqmerchant@ambitcapital.com tanujmukhija@ambitcapital.com utsavmehta@ambitcapital.com

Regions India / Asia India / Asia India / USA USA / Europe USA India / Asia UK

Desk-Phone (022) 30433295 (022) 30433289 (022) 30433053 (022) 30433259 (022) 30433169 (022) 30433268 +44 (0) 20 7614 8374

E-mail deepaksawhney@ambitcapital.com dharmenshah@ambitcapital.com diptimehta@ambitcapital.com nityamshah@ambitcapital.com pareespurohit@ambitcapital.com praveenapattabiraman@ambitcapital.com sarojini@panmure.com

Production Editor

(022) 30433247 (022) 30433284

sajidmerchant@ambitcapital.com
joelpereira@ambitcapital.com

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Technology Explanation of Investment Rating Investment Rating Buy Sell Disclaimer

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