IT
Soft quarter exacerbated by cross-currency headwinds; we stay selective
Q3FY2017 result expectations
A weak quarter: The October-December quarter has seasonally been a weak quarter for the IT companies, owing to furloughs and lower number of working days. This time, the already challenging business environment was further impacted by the cross-currency headwinds (led by depreciation in GBP/EUR/JPY by 6%/4%/7% against USD) and project-specific issues. Infosys’ constant currency (CC) revenue growth performance will be marred by ramp-down of RBS (LON:RBS) deal, whereas Tata Consultancy Services’ (NS:TCS) CC revenue growth will be led by recoup of India business revenue worth Rs180 crore. On an organic basis, Tech Mahindra (NS:TEML) will deliver best-in-class CC revenue growth of 2.9% QoQ (inorganic growth at 3.4% QoQ), followed by HCL Technologies (NS:HCLT) (1.7% QoQ; inorganic growth at 2.8% QoQ), TCS (1.6% QoQ), Wipro (NS:WIPR) (0.5% QoQ; inorganic growth at 1.2% QoQ) and Infosys (NS:INFY) (a decline of 0.2% QoQ). On the margin front, we believe that the OPM of top IT companies during Q3FY2017 will be adversely impacted on account of seasonality (Q3 being a traditionally weak quarter), cross-currency headwinds, wage revision (HCL Tech) and ramp-down of deals (Infosys). This will be offset by rupee depreciation and operational efficiencies to some extent. We believe that Tech Mahindra could see an improvement in margins (led by seasonally better quarter in profitability for Comviva and absence of one-off expenses incurred in Q2FY2017), while margins for TCS and Wipro (IT servcies’ EBIT margin) will remain intact on a sequential basis, driven by rupee depreciation benefits and operational improvements.
Key issues to watch out for would be: (1) Commentary on CY2017 annual IT budgets, budgeting cycle for verticals like Healthcare and demand outlook trend on verticals like BFSI, Retail etc
(2) Measures to mitigate risk from the potential increase in minimum wage for H1-B visa workers
(3) Commentary on positioning in the new-age digital/platforms/automation technologies and growth prospects in this space
(4) Commentary on margins and pricing outlook and
(5) Impact on businesses in view of weak global growth, protectionism, disruptive technologies and macro-economic uncertainties.
Outlook:
Uncertain demand environment, macro issues yet to subside: In Q3FY2017, the performance of the top IT companies will remain subdued, owing to cross-currency headwinds, company-specific issues, furloughs and lower number of working days. Further, the potential change in US visa policies, protectionism and ongoing Brexit-linked uncertainties could delay clients’ CY2017 budget decisions in certain verticals. However, we see traction in some verticals (ERD, BFS, etc) and higher capital allocation towards disruptive technologies, which could accelerate the overall industry growth in the coming years. We maintain our stance that the IT industry is in a transition phase, focusing on local hires and modernising the best practices for its legacy businesses. This transition phase will take some more time (~2-3 years) and would result in volatility in earnings in the near to medium term.
Valuation:
Reasonable; macro uncertainties cloud stock outperformance: Though after the recent correction in stock prices, the valuations of IT companies (trading below their historical P/E multiples) look inexpensive, the potential minimum wage hike for H1-B workers, along with lingering macro-economic uncertainties will restrict any major outperformance in the near to medium term. We continue to remain selective in terms of preferred picks in the IT sector, as these companies are investing and building new-age technologies in an efficient manner for driving sustainable growth in the coming years. Given that valuations are reasonable and a major de-rating is already behind, we see select buying opportunity from a long-term perspective (12-15 months time horizon).
Preferred picks: HCL Tech and Infosys (in large-cap space) and Persistent Systems (NS:PERS) (in mid-cap space).