citi on indian mid caps it sector

Indian IT Services: Mid-Caps
Lack of Diversification/Operating Leverage Hits 1Q

Lack of operating leverage; sharp margin decline — 1QFY08 results witnessed
sharp margin declines across mid caps highlighting the lack of operating leverage
in the models while tier1 companies demonstrated significant operating leverage.

Lack of diversification/client issues impact growth — Lack of diversification/client
issues also impacted growth rates in Hexaware/Sasken. Hexaware's growth was
impacted by ramp downs in two top 10 accounts while Sasken was impacted by
continuing weakness in the telecom OEM space.

No near term respite in sight — 1QFY08 results were poor and while we do expect
performance to improve in the coming quarters, it is not enough to prevent a
material downgrade in our FY09/FY10 estimates.

Revising estimates — We are cutting our EPS estimates by 6% – 20% for
Hexaware, Sasken and KPIT. This is to factor weak 1Q, higher impact of rupee
appreciation and company specific growth related issues. We raise our estimates
for Mphasis by 13-17% to factor EPS accretive EDS India merger.

M&A possibility exists; to support valuations — Valuations at close to historic lows
largely factor in the poor 1Q performance and cloudy outlook. At current valuations,
some of the stocks could be attractive M&A plays, in our view.

Prefer Tier I to mid-tiers; Mphasis is top pick amongst mid-caps — Amongst midcaps,
we maintain Mphasis as our top pick. For rest of the coverage, despite a
sharp fall, we do not see any near term triggers. We expect Tier I stocks to
outperform mid-caps – Infosys/TCS are our top picks in the large cap space.