Published on 7/08/2017 5:47:39 PM | Source: Kotak Securities Ltd

Technology Sector Update - Tactical margin levers exercised well - Kotak Sec

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Tactical margin levers exercised well.

Indian IT reported weak growth. Margins were not as bad considering rupee headwinds and seasonal costs due to extreme cost optimization and increase in utilization (aggregate headcount of Tier-1 IT declined). Earnings were better courtesy Fx gains. Brace for weak growth in FY2018 as drag from legacy business exceeds upside from digital business and there is no pickup in US BFS spends as yet, optimism notwithstanding. Stocks are inexpensive and high payout provides support to stock price but lack triggers.

 

1QFY18—lacks seasonal strength

June 2017 quarter lacked characteristic seasonal strength. Tier-1 IT companies reported 0.2-2.7% sequential organic c/c revenue growth. Reasons for weakness are well-known—structural challenges in retail industry, regulatory headwinds in US healthcare vertical and no pickup in IT spends of US BFS clients. Growth was relatively better for Infosys and TCS but a tad soft for others. Among mid-tier companies, Hexaware impressed with 4.9% c/c sequential growth. Mindtree and L&T Infotech reported modest 1.2% and 1.5% organic c/c qoq growth while Tech M reported 2% decline.

 

North America drags, Europe better than expected

North America grew slower than the company average for most players. It was due to no pickup in IT spends of BFSI and structural challenges in retail in addition to weakness in healthcare; these three verticals account for 45% of North America IT spends. Management commentary on this geography didn’t suggest any immediate pickup even as the companies remained optimistic about increase in BFS spends. Continental Europe was a surprise performer in June 2017 quarter. Indian IT companies are investing for growth in markets other than North America; however, improvement is not adequate to offset weakness in North America. Another reason for sluggishness is lower number of large deals and smaller deal sizes. Indian IT’s commentary on digital opportunities was more optimistic even as progress lags expectations.

 

Margin defense led by impressive uptick in utilization and extreme cost optimization

Most Indian IT companies defended margins quite well in view of headwind from rupee appreciation in addition to wage hike and visa costs. Better-than-expected margin performance was driven by

(1) increase in utilization up to 200 bps qoq and 370 bps yoy for Tier-1 IT. Indian IT have calibrated hiring; net headcount addition of Tier-1 IT was negative for the first time,

(2) lower wage inflation and pushback of wage-hike rollout, and

(3) extreme cost optimization. While margin performance has been impressive, it was driven by tactical levers. The more sustainable automation-led margin defense is still awaited. We note that net profit of most companies was better than estimates on higher other income driven by forex gains.

 

Brace for another tough year; we like Infosys in the IT pack

Slowdown in growth rates is due to synchronized sequence of negatives—we do expect rebound in growth rates, but it will be only for a select few who invested in digital capabilities and are well-positioned to defend their share of business in traditional areas. TCS, Infosys and Mindtree appear well-positioned in this journey. Putting a valuation layer as well to the underlying inherent business model strength, Infosys stands out as the most attractive; this, of course, comes with the caveat of business distractions emanating from the continuing friction between the founders and the board.

 


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