We are upbeat on the demand outlook for India IT services over FY11-13. Despite the recent sector outperformance, likely earnings upgrades should support valuations. Large caps should continue to grow their wallet share vs midcaps. Infosys is our top pick and we have Buys on TCS and HCL Tech as well.

Large caps could see a US-dollar revenue CAGR of more than 20% over FY11-13F
We see our large-cap Indian IT services universe posting an FY11-13F US-dollar revenue CAGR of more than 20% – despite a high base – notably driven by the following: 1) a better earnings outlook for clients in key verticals – banking financial services and insurance (BFSI), retail and manufacturing; 2) major opportunities from the renewal of outsourcing deals (a total contracted value of US$174bn over the next two years, according to IDC) and the Indian companies' growing wallet share of global deals; 3) rising revenue growth from Europe and discretionary spend from FY12; and 4) other drivers, eg, global sourcing from emerging verticals, SME business and outsourcing from captives to third-party vendors. Given the above, we expect Infosys to take a more confident stance on FY12 guidance (due in April 2011).

Margin challenges look manageable for large caps
Given increasing demand, supply side issues in offshore delivery are likely to pose margin challenges, in addition to the effect of currency volatility. However, we believe these will be manageable for the large caps (including Infosys and TCS; we think the worst on margins is in the past for HCL Tech) thanks to: 1) a likely 1-2% pa improvement in constant-currency pricing in FY12 and FY13; 2) efficient management of the employee bench and experience mix given the greater certainty on the IT spend-to-budget ratio in early CY11; and 3) other levers including scale benefits, improving profitability at subsidiaries and greater offshoring.

It is time to be selective; we recommend Buying Infosys, TCS, HCL Tech
Despite the recent sector outperformance, we expect likely earnings upgrades to support valuations. We recommend giving a greater weighting to companies with: 1) the appropriate portfolio mix to capture growing opportunities; and 2) greater headroom in terms of margin management or a better risk-reward ratio with reasonable valuations. Infosys is our top pick of the big-four large caps, followed by TCS and HCL Tech. We expect midcaps to struggle on revenue/earnings growth (we initiate with Holds on MphasiS, which is our preferred midcap pick, Satyam and Tech Mahindra). Key risks to our positive view are: 1) further deterioration in Western economies; 2) sharp INR appreciation vs the US dollar; and 3) austerity and resulting protectionism measures in western economies.