The Q4 results continue to reinforce our cautious outlook on demand in the sector, as highlighted in our Anchor Report: Outlook 2016: Navigating tech transitions. The key trends visible in Q4 were: (i) Organic revenue growth remained modest at 8.1% y-o-y (8.6% overall) in USD terms and 10.1% y-o-y (10.6% overall) in constant currency (CC) terms (versus a near term peak of ~14%) and three out of four companies were below consensus on growth, (ii) within large verticals, BFSI (soft at 3 out of 4 companies) and Manufacturing continue to show slow traction while Retail and Healthcare remained strong, Energy shows signs of stabilisation and Telecom seems to be seeing a recovery, (iii) Within services, ADM and enterprise solutions continue the sluggish momentum, while IMS/ Engg. Services and Testing were the faster growing services, (iv) no uniform demand trends across any segment, generally with two players performing and the other two sluggish.
Further, we see risks to consensus margin expectations as no seasonal improvement was seen in the Jun-Mar period, with impending wage hikes, continued pricing pressure, increased visa fees and INR appreciation likely putting pressure going forward. Margins missed our expectations for two of the four tier-1 IT players and outlooks were stopped at HCLT and are likely aggressive at TCS. Aggregate Ebit margins at 24% are second lowest in the last 5 years and margins across players are down y-o-y despite ~7-9% INR depreciation.
The key positives were (i) US growth has remained steady in the ~9-11% y-o-y range for the past nine quarters; (ii) Healthcare continues to lead growth and the Retail improvement seen since second quarter sustained in Q4; sluggish segments Telecom/Energy & Utilities performed better; (iii) IMS, Engineering services and Testing continued to lead growth.
In terms of commentary, BFSI growth outlook was divergent—positive at INFO/TCS and cautionary at HCLT/WPRO and CTSH. We side with the latter on weaker client financials impacting BFSI demand with a lag of 2-3 quarters.
Overall, the top-four Indian IT companies recorded USD revenue growth of 1.7% q-o-q and aggregate USD revenue growth of 8.6% y-o-y. Ebit margin was flat q-o-q at 24% and PAT grew ~9% y-o-y. Following the Q4 results, our FY17F/18F earnings estimates fell by ~2-4% for HCLT/WPRO, largely owing to lower growth and margin assumptions, while it was largely unchanged for INFO/TCS. Our earnings are based on a USD-INR assumption of 66.5 over FY17/18F.
Steady US growth: In the context of the overall softness in revenue growth, US growth for tier-1 IT (ex CTSH) has been steady at ~9-11% y-o-y for the past nine quarters and the commentary on the US remains more positive from companies. However, sustainability is key in light of macro demand indicator deterioration, which feeds into demand with a two-three quarter lag.
* Strength in Healthcare and sustenance of improvement in Retail: In Q4, healthcare remained the fastest growing segment for tier-1 IT at 20% y-o-y in CC, and the improvement in Retail seen in Q2 sustained with the segment growing at 13% y-o-y CC in Q4. Energy, a segment that has been sluggish due to oil price impacts, saw slight uptick and grew at 12% q-o-q in CC, while Telecom, another sluggish vertical, saw improved momentum with 13% y-o-y growth in CC terms in Q4.
IMS, Engineering services and Testing continue to lead growth: While IMS and Engineering services have seen some deceleration of late, the growth still remains ahead of the aggregate. Testing continues to exhibit steady outperformance vs overall growth, while BPO is in line. We continue to remain more positive on growth in IMS/BPO/Engineering services and Testing vs ADM/ES. HCLT with ~60% exposure to these services is better off vs its tier-1 IT peers.
Overall growth remains soft: Overall organic revenue growth in Q4 remained soft at ~8% y-o-y in US and ~10% y-o-y in CC due to: (i) weaker macro, (ii) cross currency moves, (iii) sluggish large segments (ADM/ES/BFSI/ manufacturing). The exit growth in Q4 was weaker than last year for 3 of 4 companies, which will likely create headwinds on growth in FY17F.
* Divergence in demand across segments: No segment showed consistent performance across all the players, generally with most segments seeing two players performing better and the other two sluggish. This suggests to us that the overall demand environment is still challenged and individual positioning of players is more important in determining who will see stronger growth. INFO did better across more segments than HCLT/TCS/WPRO.
Europe decelerated further to materially below US growth: In the past, Europe has consistently outperformed US revenue growth for tier-1 IT. However, in Q4, Europe CC growth came down to 7% y-o-y, falling below US growth of 11% y-o-y. Only INFO was able to buck the growth slowdown in Europe, with WPRO/HCLT performing the worst.
Margin trends are a concern: The margin miss at three of the top-four companies, with HCLT stopping margin guidance and TCS guidance of 26-28% Ebit margins looking difficult was a key concern. We see margins to be an area of concern given INR appreciation, impending wage hikes, and continued pricing pressures. We are below consensus in terms of our margin expectations for tier-1 IT companies.