ITs not stuck

Updated: Jun 16 2014, 09:17am hrs
In this report, we derive cues for the India IT services sector by looking at macro-economic demand indicators and the financial performance of key client industry segments. We also review how stocks, currencies and valuation have moved. Key observations:

Positive demand indicators: The US has continued to underperform for tier-1 IT (the US has grown at 11%, vs 13% aggregate and 20% Europe growth over LTMlast twelve months), however, we think macro indicators in the US suggest a possible acceleration from Q2FY15F (forecast) onwards as:

(i) demand should start to reflect recent PMI (Purchase Managers Index) improvement (from 50 to 55), as IT services demand typically lags PMI by two to three quarters; (ii) US consumer and CEO confidence show a steady trend; and (iii) job additions are seeing a strong recovery (four months in a row of 200k+ additions) while jobless claims and the unemployment rate continue to decline.

While most industries in the US are seeing growth in operating income, the pickup in revenue growth is not broad-based yet. BFS (banking and financial services) retail and oil & gas seem to still have some issues. Typically, broad-based client financial improvement is reflected in improvement in IT services demand with a two-to-three quarters lag.

Nomura economists expect the US economy to rebound from Q2 onwards, with GDP growth may remain steady at 3% (annualised) for the rest of the year, post the fall in Q1 due to weather and inventory correction. UK GDP will grow by 2.9% in 2014 (vs 1.7% in 2013) while Euro area GDP will grow by 1% in 2014 (vs -0.4% in 2013).

Tier-1 IT revenue growth should bottom out in Q1 and improve thereon: Tier-1 IT aggregate revenue growth has shown some moderation over the past two quarters to 13.5% y-o-y in Q4FY14 (from 15.5%). We expect y-o-y growth to bottom out in Q1 and improve progressively thereon.

Valuations attractive post under-performance: The IT sector has under-performed the Nifty by 26% YTD. Post this under-performance, valuations for tier-1 IT are in line with historical averages and at par with the market (vs historical premium of 20%), which we believe is attractive.

Remain overweight; top BuysHCLT, TCS and TechM: We are overweight on the IT services sector on: (i) the continuation of the strong growth momentum in IMS(infrastructure management services)/BPO/Europe; (ii) macro improvements in the US translating to better US demand from Q2 onwards; and (iii) attractive valuations (post 26% under-performance) given EPS CAGR of 14% over FY14-16F for tier-1 IT.

Reliance

We prefer companies where we see higher revenue predictability and higher positive surprise potential. In that light, HCLT, TCS and TechM are our top Buys among India listed names.

Nomura