Cross-currency headwinds and seasonal weakness to subdue revenue growth in the IT sector...
Rating: Add -Infosys, Tech M, TCS, Wipro
Reduce – HCL Tech
Q3FY15e preview—currency to sway results: Q3 will have cross-currency headwinds of 160-220 basis points besides the usual seasonal weakness, resulting in muted 0-1.2% dollar revenue growth. Commentary on the magnitude of increase and timely closure of IT budgets and deal pipelines will be important—we expect 2015 to be similar to 2014, if not better, in terms of growth. Stock prices corrected 5-10% over the past month and offer reasonable upsides of 12-20% from current levels. Infosys and Tech Mahindra are our top picks in the sector.
Seasonally weak quarter: Tech Mahindra to lead industry on growth: The December quarter is seasonally weak and impacted by holidays and furloughs across many verticals. We expect tier-1 IT companies to report sequential organic constant-currency (c/c) revenue growth of 2.2-3.5%. Tech Mahindra (TM) will lead the industry with organic c/c growth of 3.5%. Infosys will report 2.8% and is set to achieve the lower end of 7-9% revenue growth guidance based on end-September 2014 currency rates. TCS will report muted 2.2% growth (c/c). Among mid-tier companies, Mindtree will grow 2.5% in c/c terms.
Currency to play spoilsport on dollar growth: The euro, British pound and Australian dollar depreciated by 5.9%, 5% and 7.7% in Q3. The currencies account for 5-15%, 5-20% and 5-6% of revenues for Indian IT. Depreciation of currencies will impact reported US dollar revenues by 1.6-2.2%. The rupee’s depreciation by about 2.7% against the dollar means the consolidated impact on revenues in reported currencies, the rupee, will be marginally positive. TCS, HCLT and Wipro will be hit the hardest by currency movements. Benefits at the margin level from currency movements will be limited to 30 bps. Year-on-year net-profit growth for the big three will slow to mid-single digits.
2015 will be similar to 2014, if not better, on demand: In 2014, demand strengthened in select areas and weakened in some—we expect 2015 to be no different. Positives are (i) an improving economic scenario in the US, (ii) expected recovery in IT spending in the banking vertical after the past two years were impacted by regulatory fines in the US; and (iii) large deals and continued market-share gains. Negatives are (i) the impact of the decline in oil prices on energy and utilities, which will impact select segments of manufacturing, and (ii) volatile demand in emerging markets.
On the whole, we believe demand will be similar to that in 2014, if not better. Funding of digital initiatives by clients through incremental spending rather than through self-funding mechanisms can be an additional growth driver. We highlight that the traditional link between earnings and growth in IT spending has not worked post-the financial crisis. We will watch for commentary of companies on the outcome of clients’ budgeting.
Stock corrections offer a good buying opportunity: Stock prices corrected 5-10% over the past few days due to concerns about demand slowdown and cross-currency impact. We believe concerns about demand are exaggerated based on factors highlighted above. The cross-currency impact without a compensatory rupee benefit (rupee depreciation against the dollar) will be a concern; however our economist forecasts depreciation of the rupee against the USD to 63 in FY16 and 65 in FY17 We maintain our constructive view on the sector. Infosys (low hanging fruit captured, hard work starts but the company is on the right track) and Tech Mahindra (market share gains in the telecom and enterprise segments) are our top picks.
A close look at individual players
Infosys—will narrow guidance range. We forecast sequential c/c revenue growth of 2.8%, USD revenue growth of 1.2%, flat Ebit margin and net income on a year-on-year basis. We expect Infosys to narrow guidance to 7%, in USD terms, for FY15. We expect progress on key metrics that are important for turnaround—(i) decline in attrition from Q2FY15 quarterly annualized levels of 24.8%, (ii) higher growth in infrastructure services, and (iii) improved client metrics. We have an Add rating on the stock, with target price of R2,350.
TCS— the worst is in the price. We expect TCS to deliver c/c revenue growth of 2.2% and flat revenues in dollar terms. TCS had indicated that dollar revenue growth in Q3 will be impacted by seasonal weakness, softer demand and cross-currency impact of 220 bps.We forecast Ebit margin improvement of 20 bps quarter-on-quarter. Focus will be on TCS commentary on demand
(after it missed expectations in three out of the past four quarters) and implications of workforce optimisation. We have
an Add rating on the stock with a target price of R2,800.
Wipro—the biggest growth driver is now the biggest concern. We expect Wipro to report dollar revenue growth of 1% and c/c revenue growth of 2.8%. Performance will be marginally below the mid-point of 2-4% guidance range. Focus will be on implications of oil prices on IT budgets of energy clients. Energy and utilities are Wipro’s fastest growing practices, accounting for 17% revenues. We expect Wipro guidance of 1-3% c/c revenue growth in Q4. We forecast flat margins for Q3. Maintain our Add rating, with a target price of R675.
HCLT—concerns about growth emerge. HCLT’s guidance indicates a 220bps cross-currency impact on dollar revenue growth. We expect c/c revenue growth rate of 3.4%, and margin decline owing to wage hikes and investments in business. HCLT will be impacted by dual factors of increased competition in the infrastructure management business and unsustainable margins. We retain our Reduce rating.
Tech Mahindra—will lead the industry on growth again. We forecast c/c revenue growth of 4.8% and dollar revenue growth of 2.8%. On an organic basis, we expect c/c revenue growth of 3.5% with an additional.1.3% accruing from consolidation of the Mahindra Engineering Services acquisition. Revenue growth will be led by a ramp up of large deals in the enterprise segment. Growth from the telecom vertical will be muted. Ebitda margin will be flat. Tech Mahindra will continue to lead the industry on growth due to blockbuster deal wins in telecom and improving positioning in the enterprise vertical. We maintain Add rating.
—Kotak Institutional Equities