India Technology - Tapering growth and volatility weighing on valuations: Anand Rathi Financial Services

In FY15, cloud transitions started to impact growth rates for Indian IT companies, leading to investors getting jittery about the outlook and volatility of the sector, even as companies continued to generate strong cash flows and strengthened balance sheets. Giving a higher weight to growth in technology companies, we recommend aligning IT portfolios to differentiated midcaps like Persistent or to companies in special situations like HGSL and KPIT where the cushion provided by valuation is too high to be ignored. We also recommend avoiding relative value traps in these times.

Not much difference in operating cash flows; capex holds the key. Indian IT companies improved cash generation in FY15, driven by improved working capital days (lower receivable days and higher payable days) amid slowing growth. We did not find much difference in the cash-generation ability of various companies but observed that capital allocation (capex) turned out to be the key reason for divergence in FCF generation. HGSL and Mindtree reported one of the highest capex-to-EBITDA ratios in FY15, suggesting that the current level of margins did not adequately cover capital costs for these companies, relatively.

Goodwill write-offs to improve RoEs. Many companies utilised FY15 to trim their balance sheets of goodwill and disputed receivables on fixed-price projects. KPIT, Firstsource and Hinduja Global cumulatively wrote off `9386m, a little more than their annual cash generation. For Firstsource, these transactions occurred during the tenure of earlier management and therefore, were no longer reflecting current business expectations. RoEs for these companies, consequently, will start trending up, in our view.

Slower growth and increased volatility. Indian IT companies growth expectations entering into FY15 were quite high;, as the year progressed, however, they turned out to be quite divergent in terms of performance with companies like Accenture accelerating growth and Indian IT (Cognizant being no exception) experiencing some softness in its traditional business. For those who did not notice, Wipro outpaced Infosys in FY15 in revenue growth and was quite comparable in EBITDA growth despite being hit by weakness in the E&U vertical towards the second half.

What to expect from IT now, and winners for FY16. We believe that the visibility of quarterly earnings for IT companies (including large caps) is on a decline for various reasons; thereby, heightening volatility in equity returns. Also, in times of transition, the traditional wisdom of switching to large caps, and valuation arguments to avoid midcaps as an asset class might not work well for investors. We recommend tilting portfolios in favour of specialised midcaps with better growth prospects. We recommend a Buy for Persistent Systems, Hinduja Global and KPIT (special situations). Top Sell: Mindtree.

Source : Equity Bulls

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