1. Indian IT Services: Shaken, not expensive

Indian IT Services: Shaken, not expensive

Demand’s unlikely to improve, but the valuations are reasonable

By: | Updated: December 28, 2015 12:07 AM

We expect 2016e’s industry growth to be just about in line with   2015’s in constant currency terms. However, stocks are likely to do better after the  valuation de-rating and downward earnings revisions in 2015. Key themes likely to drive demand and stocks in 2016e or FY17e include demand upside from digital, impact of growing multi-dimensional competition, macro-economic outlook and its impact on BFSI spending and continued impact of growing unfavourable base.

We think digital will continue to dominate incremental IT spending globally. However, in our view, digital technologies are just an evolution of traditional areas of IT spending and thus are unlikely to materially change the overall  trajectory of IT spending and consequently the Indian IT sector’s growth. Without digital spending, global IT spending could have been flat to negative currently.

Further, while Indian companies continue to gain market share globally, the pace of market share gains is likely to be impacted by the growing prominence of majors (eg, Accenture), niche players (eg, EPAM, Luxoft, Globant, etc) and GICs (captives) in India. This is likely to restrict positive surprise on growth.

Even though consensus expectations have come down in recent quarters, we estimate that the top-five outsourcing companies still need c.$6.5 bn of incremental revenues in FY17/18e to achieve 11-12% revenue growth, which would be the historical peak, and not easy to beat. A rising tide lifts all boats. The banking, financial services, and insurance industry (BFSI) appears to  have stabilised and an anticipated pick-up in earnings growth in 2016/17e may lead to higher spending which may lead to beating of our current estimates. Admittedly it’s a macro call and at this stage only a hope.

Valuations have converged as well, with Infosys/TCS and Wipro/HCLT/ TechM at comparable levels. We have a Buy on Infosys due to its improved long-term growth prospects, although TCS could see a near-term catch up due to less demanding valuation relative to its historical level. An unfavourable base remains the key negative for TCS in the  long term. Among Wipro, HCLT and TechM, only HCLT is Buy rated due to its better growth visibility.

Our investment thesis for the sector remains a push-pull across multiple factors. On the one side, we have tailwinds from digital proliferation and a likely increase in IT spending with the macro  recovery; on the other hand, a growing unfavourable base and increasing competition remain headwinds to growth. Balancing these, we expect 11-12% revenue growth in FY17e. Upside risks  seem purely macro dependent and contingent on an increase in overall global IT spending.

We think it is important to highlight the digital opportunity and if that can single-handedly drive the sector’s growth and returns. We believe digital will continue to dominate incremental spending in the sector. However, in our view, digital spending represents the  natural evolution of traditional IT spending and not a major change in the course of spending. Without digital spends, global tech spending could have been flat to negative currently.

Overall, we expect global IT spend to grow 2-4% in the near term. Usually this would have led to 14-15% growth in the Indian IT players (based on historical market share trends). However with increased competition from aforementioned companies, growth is likely to be restricted to 11-12%.

For Indian IT majors, valuations have converged, with Infosys/TCS and Wipro/HCLT/TechM at comparable  levels. The low-hanging returns from Infosys (particularly vs TCS) now appear to be over. Valuations have nearly converged and expectations have been reset  upwards for Infosys by the Street. TCS, on the other hand, has underperformed sharply in the recent few quarters (5 out of 6) and suffered a consistent de-rating. As at market close of 18 Dec at R2,417, TCS was trading at only a 5% discount to Infosys at R1,083 (forward P/E) and has growth expectations almost converging with Infosys. Further, downside risk to TCS’s margins is lower than for Infosys. Consequently, TCS shares could play catch up.

We maintain our Buy rating on Infosys based on the following: growth is still accelerating and a converged growth with TCS in FY17e should lead to further expansion in valuations for Infosys; growth improvement is likely to come from a further pick-up in large deal wins and improvement in client mining across client buckets and not just with large clients; further, in the next 12-24 months we expect the SAP market to pick up, which is likely to accrue well for  Infosys; and last, Infosys’ asking rate in terms of absolute revenues required to achieve our growth expectations for FY17 is still nearly half that of TCS. In our opinion, Infosys is rapidly catching up with TCS on digital and automation capabilities and a lower asking rate should remain a tailwind for Infosys vs TCS. Near-term margins are a concern for Infosys, but the market may overlook this and focus on growth (which should continue to improve) in FY17e.

Stock valuations have moderated over the past year and TCS has now converged with Infosys at 17x FY17e earnings. The stock has corrected (6%), the most in 2015 among the Top 4 IT companies. In our opinion, the company has a well-diversified portfolio and a strong digital practice. We expect FY17e top-line growth  (12% y/y) to be better than the industry average. Overall, TCS we believe has lower downside risks to earnings (vs peers) as well in the near term. We think large scale remains the key challenge over the next 2-4 years and limits positive growth surprise for the company, and this is the main reason for our Hold rating.

We reiterate our Buy on HCLT due to better growth visibility, especially compared to Wipro and TechM. We think HCLT has now increased its focus on the rebid IMS market and is winning larger deals ($300m-1 bn) vs just mid-size deals ($100-200m) in the past. Outside IMS, while the applications business remains weak, we think deal momentum can improve in the ER&D business, as witnessed in FY15. This remains an upside risk to our top-line estimates.

We continue to see growth headwinds for Wipro, owing to its high exposure to energy vertical (~15% of FY15 revenues) and low exposure to US banks. Wipro has still not been able to manage  the ‘mining’ vs ‘hunting’ balance. In a ‘normal’ demand and growth environment—client mining (revenue/client) and hunting (clients acquisition) equally contribute to revenue growth.

TechM continues to rely heavily on telecom growth and we think the integration of low-margin recent acquisitions increases risk to its near-term growth profile. Given the increased risks associated, we expect the stock to trade at a discount to HCLT.

We reduce the target valuation multiples across most of the companies to factor in the growing base and higher competition leading to our lower growth outlook in the long term. We believe a fair valuation multiple for the IT sector should be c.17-18x based on the three-stage growth model. Within the sector, companies with better growth outlooks are likely to sustain a premium to this sector average valuation P/E multiple. Consequently, we have target valuation for Infosys and TCS of 20x 12-month forward earnings and HCLT at 17x and both Wipro and TechM at 15x. This leads to a sector average multiple of  17.5x, in line with our three-stage model. We expect Infosys and TCS to trade at similar valuations as growth at both companies should converge over the next 1-3 years. In the near term, TCS has lower risk to earnings and may trade up temporarily. However, in the long term, its unfavourable base skews risk-reward in favour of Infosys. We expect TechM to trade at a discount to HCLT due to high concentration risks.

Gr3

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