Indian IT services are in transition due to new technology trends (Digital-social, mobile, analytics, cloud and IoT) and shifts in spending authority at clients from IT to business. Thus, we expect diverging demand trends across segments and changes in the nature of demand within segments too. This coupled with weakening macro demand indicators (client financials and US PMI) limits the potential for demand to accelerate in FY17F. We recommend staying selective and prefer IT services names with: (i) a higher skew towards faster growing areas (eg, digital, infrastructure management services (IMS)/engineering services, Europe, healthcare/manufacturing); (ii) potential for market-share gains in the more sluggish segments (e.g ADM/BFSI); and (iii) less exposure to work subject to cannibalisation. While fundamentally demand looks less than exuberant, reasonable valuations at near five-year averages and USD strength lend defensiveness to the sector.
Key tech transitions that are likely to shape demand for the industry
As CIO budgets contract, segment penetration, market share gains and level of automation will remain big growth drivers. However, increases in non-CIO spend will shift demand in favour of Digital leading to significant transitions like (i) on-premise s/w to SaaS; (ii) on-premise datacenters to cloud; (iii) underexploited corporate data silos to open data flows; (iv) desktop-based systems to mobility and (v) from mandate of reliability of IT systems to dual mandate of reliability and agility. The negative impacts on legacy work and newer opportunities will co-exist; hence business mix will decide which companies do better. Accenture clearly has lead versus Indian IT, but we expect HCLT/TCS to gain from back-end digital and CTSH/INFO/TCS to gain from front-end digital demand.
HCLT ( HCL tech) (~60% exposure to IMS/engineering services and BPO, coupled with reasonable valuations), CTSH (Cognizant) (strong digital capabilities, market-share gains in BFSI and nearly half of revenues from faster growing healthcare/manufacturing), followed by Infosys (focus on non-CIO spending and improved performance in legacy segments).
Indian IT: Cautious on demand
In India, we are cautious on the possibility of demand acceleration in FY17F, mainly owing to the diverging demand trends and weakening macro indicators
* Sector remains in transition and demand trends are diverging across segments: The industry is grappling with fast changing demand dynamics across segments, driven by technology changes and a shift in spending authority from IT to business within client organisations. Even within segments, the nature of demand is shifting, with (i) deal size and duration getting smaller, (ii) increasing complexity, and (iii) annuity characteristics of business seeing a change with more transformational project based work coming from clients. Further, IT services vendors need to adjust to the dual mandate of reliability and agility of IT systems, which have repercussions from staffing/skills /sales and investment perspectives. These transitions are leading to diverging demand trends across segments:
* New vs legacy offerings: Smaller newer technology offerings (digital- social, mobile, analytics, cloud and IoT) and IMS/engineering services are growing well, but this is being countered by larger more sluggish legacy segments like application development and maintenance (ADM) and enterprise application
* ADM is seeing deflationary impacts as automation, competitive pressures and rationalisation in the app landscape counter legacy app modernisation efforts.
* EAS is seeing cannibalisation of on-premise software implementation and support work, despite growth in SaaS (software as a service) and analytics, which are smaller.
* IMS, a faster growing service, is also seeing a change in the nature of demand with: (i) a shift from more annuity monitoring/troubleshooting work to more project-based transformational work across cloud/mobility, (ii) a shift from manpower-led to software/automation-led work, and (iii) new opportunities to take complete ownership of work related to multiple cloud instances (public/private). Increasing complexity and changes in the nature of the work are causing volatility in this segment.
* US vs Europe: The US market has grown steadily in the 10% y-o-y range for the past six quarters, but has not accelerated despite stronger macro. Meanwhile, Europe is outperforming on growth (ex-currency impact), driven by cost-focused demand.
* Across verticals: BFSI/retail/ telecom/energy, which contribute ~60% of tier-1 IT revenues, are underperforming, while healthcare/manufacturing are growing well. We expect these divergent trends to continue in FY17F and believe that in such a scenario, stocks with better business mix will drive growth and share price performance.
* Macro demand indicators are not supportive and suggest decelerating trends: We see worsening key macro demand indicators, which typically affect demand with a 2-3 quarter lag: (i) decelerating or negative revenue growth trends across key client industries such as oil & gas, BFS, consumer, retail, and manufacturing at Fortune 500 US corporates; (ii) the US PMI at 48.6 in Nov-15 is at the lowest level since Jun-09, vs its previous peak of 58.1 in Aug-14; and (iii) ~20% lower monthly private job additions in the US in 2015 YTD vs 2014. This has already started to get reflected in the softer 2HFY16F outlook at tier-1 IT companies, with weak guidance at Infosys/Wipro, a pre-Q2 warning at HCLT, and the cautious tone at TCS. Weaker exit rates for FY16F will likely limit the potential for demand acceleration in FY17F.
The above mentioned factors make us cautious on revenue acceleration in FY17F versus FY16F, and we look for constant currency growth of 12% over FY16-18F (vs 14%+ in FY16F) for tier-1 IT (including CTSH).
What prevents us from taking a more negative stance is that relatively: 1) valuations at 17.8x one-year forward P/E for tier-1 IT (incl. CTSH) (~3% premium to five-year historical averages), while not cheap, are not very expensive either; (ii) a stronger USD plays to the sector’s advantage and lends certain defensiveness to the sector; and (iii) Indian IT is still available at higher than historical valuation discounts versus other defensive sectors like FMCG and pharma.
What is contributing to or dragging down Indian IT growth?
Tier-1 IT growth has seen a moderate deceleration in constant currency terms over the past 6-8 quarters, although the deceleration in USD terms has been much more material from a near-term peak of 14% y-y to 6% y-y as of Sep-15, caused by a depression of ~580bps y-y due to cross currency moves in 2QFY16. The key demand trends witnessed were:
* Continuation of market-share gains in underpenetrated segments resulting in services like IMS and engineering services growing strongly for the industry and outperforming larger traditional segments (ADM and enterprise solutions) by a wide margin.
* Divergence from a verticals perspective, too, with manufacturing and healthcare being the faster growing verticals, while BFSI/retail/telecom and energy (~60% of revenues for tier-1 IT) were sluggish.
* From a geographical perspective, Europe in constant currency terms continues to outperform the US, though lately some moderation has been witnessed in European growth, with it equalising with US at ~10% y-y in CC in 2QFY16.