The sector is going through structural shifts, with shift of spends from traditional to digital and global protectionism.
The sector is going through structural shifts, with shift of spends from traditional to digital and global protectionism. While the Indian IT firms have been gearing-up for transition for some time, we believe, the pace has gained momentum in the recent months. Management commentary during the earnings season and FY18 guidance indicates that FY18 may be similar to FY17. While the companies remain hopeful of a cyclical recovery in the BFSI vertical, retail (and also healthcare) are incremental challenges.
The cost associated with some transformational initiatives and the currency related headwind can negatively impact the margins in the near term, despite efficiency gains from automation and non-linearity. Any signs of a cyclical pick-up can lead to a significant rally in the Indian IT stocks—most of them have underperformed over the past year, hence, earnings estimates would be revised and multiples could get re-rated. Increased payouts, which have commenced, will supplement it.
HCLT remains our top pick. While the stock has outperformed the sector significantly over the past year, and has performed in line with the Indian markets, valuations remain attractive just above 12x FY19 P/E, and 6-7% FCF yield. Growth is solid and margins are stable. It is also relatively more immune to the adverse US visa changes. And HCLT would benefit from any cyclical recovery as well.
IT spends are shifting from traditional area to newer areas such as mobility, cloud, analytics and IoT collectively termed as digital by management, and there is also some cannibalisation from cloud and automation. The companies have also indicated plans to accelerate local hiring. Q417 was a soft quarter for the sector—the top-five companies grew in the range of 0- 1.8% (Infosys and Wipro at the lower end and HCL Tech at the upper end). Margins too were weak in general.
While such a softness in the results was well expected, Infosys and HCL Tech revenue growth guidance for FY18 was slightly underwhelming. Among the mid-cap stocks, Mindtree, L&T Infotech and Cyient had a decent performance. Cyient and L&T Technology Services management had an upbeat commentary for FY18 as well. Mindtree too expects a recovery in FY18, after a disappointing FY17.