IT Services Sector Update - Renewals to drive FY15 growth; Tier-1 to benefit more - Centrum

Renewals to drive FY15 growth; Tier-1 to benefit more

While commentary has been bullish about the demand environment, both ISG deal data and our channel checks indicate that much of the pipeline increase is due to renewal deals, especially in Europe. We expect Tier-1 players to match or outperform Tier-2 players in terms of revenue growth as they are better positioned to win large deals. We note that growth rates have been converging over FY13-14 as Tier-1 players started differentiating themselves in both large deals as well as new technology spending. Our preferred picks are Tech Mahindra, TCS, HCL Tech, Wipro among Tier-1 and Infotech Enterprises among Tier-2.

Dissonance between commentary and numbers explained by renewals: While there has been euphoria in many quarters about a strong demand environment for IT Services in the developed world, we think that overall IT budgets will increase only modestly given S&P 500 revenue growth remains tepid (for details see our initiating coverage "Shifting Sands => New Challenges). This thesis is supported by ISG deal data which indicates that New Scope awards declined over 2013 in both value and number while Restructuring deal contract value was virtually flat YoY with number of awards going up. This is also corroborated by our channel checks in both US and Europe.

Renewal contract sizes down, but total contract value in Tier-1 sweet spot: India-centric Tier-1 providers (TCS, Cognizant, Infosys, Wipro, HCL Tech and Tech Mahindra) have shown an ability to win contracts in the USD20-50Mn TCV (Total Contract Value) range that Tier-2 players have yet to graduate to. We expect no Tier-2 player to garner significant deals and expect the market to consolidate further in favour of Tier-1 providers.

Tier-2 outgrew Tier-1 over FY11-13, but growth differential has narrowed: Over FY06-FY13, barring FY11 onwards, Tier-2 has mostly underperformed Tier-1 in terms of growth despite the advantages of a much smaller base. There has been virtually no gain by Tier-2 in marketshare even excluding Cognizant from the Tier-1 (see Exhibit 4) and growth rates have been converging (see exhibit 5). With increasingly sophisticated managed services/ fixed price deals and investments in vertical expertise and in new areas of spending such as analytics and mobility, we expect Tier-1 to match or exceed Tier-2 growth over FY15-FY16.

Barring Infotech Enterprises, prefer Tier-1 over Tier-2: We'd earlier expressed our preference for niche mid-cap IT-ITES Services firms such as eClerx and Infotech over traditional mid-cap IT Services firms such as Hexaware, KPIT and Mindtree. But among niche mid-cap firms, only Infotech trades at a valuation that we regard comfortable and we expect limited upside for eClerx from current levels. Among Tier-1 firms, our current top pick is Tech Mahindra, followed by TCS, Wipro and HCL Tech. We remain negative on Infosys as we expect its growth to lag peers. We have rolled over our target prices to Mar-15 across over coverage universe.

Source : Equity Bulls

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