A common narrative echoing from our recent interactions with IT companies, especially mid-caps, seems to be that of margin improvement. While margin erosion was a consistent theme across Indian vendors amid changing business dynamics, select mid-caps saw significant compression mainly due to (a) acquisitions, and (b) portfolio-specific challenges leading to ad-hoc pricing pressure. With those abating, and anticipated prudent acquisition strategy – given scale unlikely is a primary to win digital business – and operational efficiency implies ex-currency margin trajectory could be on the rise. This in turn could improve EBITDA/CFO conversion too. As for growth, ISG data indicates positive momentum, but importantly growth commentary seems largely interrelated to traction in large customers. We raise target prices for our coverage universe primarily by upgrading valuation multiples to account for (1) growth recovery in FY19E, (2) margin expansion (primarily mid-caps), (3) improving EBITDA/CFO conversion, and (4) healthy yields.
ISG data positive but incremental factors at play
Analyzing 9MCY17 deal activity suggests that global IT outsourcing ACVs could likely grow yoy in CY17 after two consecutive years of decline. Deals worth a modest US$ 1.8bn in ACV need to be signed in 4Q to achieve CY16 equivalent annual ACV of US$ 16.3bn, while the past three 4Qs have averaged US$ 4.3bn. Deal activity has been better both in the US and EMEA with strength in FSI and energy, while manufacturing/travel did well in the US and CPG in EMEA. Retail fared poorly both in the US and EMEA. That said, comparing deal activity and growth rates of India vendors with a lag suggests that vendors typically have done well despite a yoy decline in signings (Refer slide 2) and implies incremental factors (large customers traction) are at play.
Large customer traction narrates company-specific commentary
Analyzing yoy growth across large customers helps comprehend company specific commentary. Wipro’s top customer grew 25.3% yoy in 2QFY18 and likely explains, contrary to peers, BFSI commentary. Similarly, L&T Tech, LTI, and Mindtree continue to witness significant traction in their large accounts
OPM improvement remains a key trigger
Analyzing OPM trends over the last 11 years suggests that only TCS and Hexaware operate at better-than-FY07-margins today. TechM margins have halved while KPIT operates at the lowest margins within our coverage universe. Margin compression within the mid-cap universe was led by a variety of factors, but acquisitions and portfolio challenges were crucial. However, commentary suggests conscious efforts are underway to improve margins led by operational efficiency, and abating portfolio challenges. This coupled with prudent acquisition strategy could improve cash generation and aid capital allocation.
Yes, 3QFY18 earnings could provide accumulation opportunities
3QFY18 constant currency (CC) revenue growth could be ‘Ok’ in a seasonally-weak quarter driven by furloughs, while reported US $ revenue growth could average 1.3%. Within tier-I’s from our coverage universe, dollar growth could range 0.4%-2.4% for Wipro, Infosys, TCS, and HCLT in that order. Note that HCLT growth includes inorganic contribution of ~0.7%. TechM revenues could grow 1.3% led by acceleration in the enterprise business and Comviva seasonality. EBITM generally would be aided by operational efficiency but would be company-specific as some have deferred wage hikes (Refer slides 30-34 for IT preview). CY18E IT budget spend patterns, demand trends in BFSI, retail verticals, and discretionary projects could be of investor interest.That said, a few mid-cap names have pre-empted margin expansion thesis well ahead in time, and are expensive relative to large-caps, while earnings disappointment and rupee (appreciated 2.3% year to date relative to 3QFY18 average) could create potential accumulation opportunities.
TCS, TechM are our top picks even as we upgrade others
As for TCS, recovery in BFSI, retail, and large deal conversion in digital could lead to positive earnings surprise, while growth in enterprise and a negligible telecom drag could help TechM. Margin expansion could be a consistent theme across mid-caps and leads to higher PE multiples. We upgrade TCS to ADD TP of Rs. 2,975 at 20x Mar’19 TTM EPS of 148.8 vs. REDUCE and Rs. 2,627 earlier and continue to maintain our ADD rating on TechM with TP of Rs. 569 at 15x Mar’19 EPS TTM of Rs. 34.1 vs. ADD and Rs. 527 earlier. Table on slide 30 highlights our revised ratings and target prices.
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