Growth visibility is reducing at the margin
HCLT top pick: We focus on the key discussions we have had with investors over the past month. Growth is likely to remain muted in FY16 (8.5-13% $). Valuations in absolute terms are close to five-year highs. Despite recent outperformance, we continue to prefer Infosys over TCS and HCL Technologies over TechMahindra.
Debate #1– guidance/hiring as demand indicators: Nasscom guidance of 12-14% growth in $ terms and CTSH (Cognizant Tech Solutions) guidance (at least 12.5% organic). Will FY16 growth be better year-on-year? The larger companies as a group have lagged Nasscom in FY15; this could continue. We believe CTSH guidance is some kind of a cap for Indian IT growth. Hiring pick-up in the last two quarters is due to very high levels of utilisation rather than accelerating growth–and could result in wage pressures.
Nasscom guidance of 12-14%
Should flattish guidance increase confidence in demand? Nasscom’s guidance of 12-14% export growth in FY16 is largely flattish vs. FY15 on a constant currency basis–leading investors to wonder whether demand environment could remain strong and revenue growth accelerate in FY16.
Actual growth at lower end of the forecast: For FY15, Nasscom indicated a constant currency growth of 13.1% – closer to the lower end of its 13-15% guidance at the start of the year. The top four companies on an aggregate will likely lag Nasscom expectation in FY15. Demand from Europe softened after H1. The top four companies on an aggregate have not grown within the Nasscom guidance range five times in the last seven years.
Reducing growth visibility presents risks: We believe growth visibility is reducing at the margin: (i) revenue pressure in traditional services like ADM (application development and maintenance) in the backdrop of flattish budgets; (ii) higher growth from shorter cycle projects like digital; (iii) instances of client specific challenges. In this context, we see higher risks for the larger IT services companies in meeting the guidance range.
Does pickup in hiring mean speeding growth?
* Hiring on the rise — Over the past couple of quarters, we have seen hiring pick up across several companies. A section of investors wonder whether this is a sign of greater confidence in the demand recovery.
* Utilisations are peaking — We think the higher hiring is a response to high utilisations, rather than accelerating growth. Growth in FY14 was driven more by uptick in utilisations as headcount growth lagged – the trend has continued in FY15. With utilisations in the sector close to peak historical levels, we see relatively limited room ahead to sustain growth by further increasing the utilisation levels and so hiring needs to pick up.
* Interesting to see what it means for wage hikes: We think the increasing hiring could lead to more wage inflation and margin pressure. The pattern of hiring is increasingly shifting towards lateral talent (complemented by higher cost subcontracting not reflected in the hiring mix)– we think due to several factors like (i) automation at lower skill levels; (ii) higher need of lateral/ specialised talent in newer areas like digital; (iii) focus on domain knowledge; and (iv) more “outcome based” and “fixed price” contracts.
Deal wins not too encouraging?
Deal wins of Indian IT companies were soft: Deal wins were also softer and need to be monitored going forward: (i) Infosys won three large deals ($220m) vs. $600-700m over the past few quarters; (ii) MindTree’s new deal wins at $46m were a notch lower ($63m in Q2). TCS/Wipro had encouraging commentary regarding deal wins and pipeline, but do not disclose the quantum of wins.
Relatively weak bookings by global peers: Accenture bookings were weak – outsourcing bookings growth was flat (on a four-quarter rolling basis), lowest in over four years. Also, book-to-bill has not been below 1x since Q1FY09. IBM services backlog was down 10% y-o-y. On a four-quarter rolling basis, services signings were down 18% y-o-y. These remain key data points to be monitored going forward.
* Debate #2 –revenue growth or Ebitda growth: There seems to be a belief that margins are not a concern. Margins over the past three years have been supported by 25% INR depreciation. If INR remains in a band and with companies getting aggressive on pricing, focus should be on Ebitda (earnings before interest, taxes, depreciation, and amortisation) growth as well–in the most recent quarter, the top five companies reported 6% Ebitda growth.
* Debate #3 – relative vs absolute valuations: This seems to be the single biggest struggle for all India investors–other important sectors are also expensive. This continues to support the sector valuations despite most agreeing that absolute upsides are limited. Our reverse DCF (discounted cash flow) suggests 12-18% 10-year Ebit growth required to justify current valuations–a stretch.
Key issues on each company going into FY16
* Infosys: Will growth pick up significantly? What about capital return? We expect 10% growth in FY16e. Capital return needs to be material to help; buyback will do little to support EPS.
* TCS: Are slow quarters client-specific or falling in line with sector growth? Our take–Given the scale, difficult to see TCS continuing to demonstrate the outperformance it has shown. We model 11% organic growth in FY16e.
* Wipro: Was Q3 seasonally strong or a change in trajectory? Our take – Deal flows help but growth volatility likely to continue. Expect 8.5% growth y-o-y in FY16.
* HCLT: Will infrastructure slow and margins fall? Our take– Infra services will still grow 20%+, much ahead of the industry and margins will decline moderately.