Indian IT: first among equals
Indian IT has achieved early success in transitioning its business model (pivot to digital), evident in its growth leadership vs. global peers. Despite improving pricing power (digital, supply constraints) and growing addressable market, global macros turning adverse will create ‘first among equals’ in the sector. Indian IT exTCS/INFY trades at a discount to its historical valuations (TCS/INFY at ~20% premium) and we maintain our stock selective stance, preferring names that have strong durability and stable core business.
In this note we ‘hit refresh’ and recount the hits and misses of 1QFY20. IT sector revenue growth in 1Q was 8.5% YoY (vs. 8.6% in FY19) contributed by Tier-1 IT at 8.5% YoY (fastest in 5 qtrs) and Tier-2 IT at 8.9% YoY (slowest in 8 qtrs). HCLT/INFY outperformed while Tier-2 IT disappointed (growth converging with Tier-1).
We have reviewed the performance and outlook of large global enterprises (top clients of Indian IT) which indicates that near term growth will be modest (lower discretionary spend). We have also run margin sensitivity on onsite cost/INR and analysed the onsite supply scenario (increasing H-1B challenges), which indicates that higher offshoring is only a partial offset. IT sector valuations (10% premium to avg & benchmark) are supported by (1) Growth outlook (9.5% CAGR over FY19-22E), (2) Strong cash generation (~70% OCF/EBITDA & FCF/APAT) and payout (~70% of OCF). Prefer TCS (scale/durability, Europe, core verticals) and HCLT (organic uptick, valuations) from Tier-1 and Mphasis (growth visibility), LTTS (ER&D leadership), Zensar (organic acceleration) and Sonata (Dynamics 365) from Tier-2. Upgrade TechM to NEUTRAL (limited downside).
* HCLT and INFY were the growth leaders in 1Q. Within Tier-1 IT, HCLT/Wipro delivered beat/miss even as aggregate Tier-1 IT was in-line. Guidance was a mixed bag with INFY/Accenture upping outlook, HCLT/Capgemini maintaining and DXC/Hexaware/LTTS cutting guidance.
* Margins have moderated by ~200bps over the past 2 qtrs (~50% impact from INR appreciation). 1Q headwinds included INR hardening, wage increases, rising visa costs, and cross currency impacts, while the sector exhibited wide performance divergence (bigger dents in midcaps). In Tier-2 IT, Intellect, Tata Elxsi, Mastek, Cyient and Mindtree missed est. revenue/margins. LTTS and Zensar delivered margin beats while Hexaware/Zensar delivered strongest growth (INR has reversed, watch this space!).
* Deal wins were steady led by strong bookings by INFY, while TCS continued to outpace (higher book-to-bill and in absolute terms) Accenture (outsourcing slice) in bookings. Share gains in digital continues vs. global peers (Tier-1 IT outpaced Tier-2, for a change).
* Enterprise discretionary spend has moderated and we notice mixed trends across key verticals of BFSI, Retail & CPG and Healthcare. BFS spend has decelerated with lower investments and tighter cost control amid macro challenges particularly within Capital market subsegment and European Banking (in-sourcing). TCS/INFY/Wipro outpaced large global peers Accenture/Cognizant.
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HDFC Securities Limited (HSL) is a SEBI Registered Research Analyst having registration no. INH000002475
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