Technology: Another tough year for Indian IT - Kotak

Our conversations with Indian IT companies, consultants and the ecosystem indicate another tough year for the industry. Muted spending, slow pace of deal closures, continuing captive shift, share and lack of much anticipated kicker to financial services spending are the contributing factors. These will lead to marginal downgrades to FY2018 revenue estimates. We maintain that companies with investments in digital will benefit from the change in business mix-led recovery even as the timing of it is uncertain. In our coverage universe, we find TCS, Infosys and Mindtree as best positioned to capture digital spending.

Expect another weak year with drag factors, a continuation of previous year's theme

Our conversations with IT companies and industry participants indicate downside risk to revenue growth estimates. None of the factors are new; in fact they are well known but these have not changed enough to lessen the drag on growth. The reasons are familiar, yet the articulation of the same is in order noting the imminent downgrade to our and Street's revenue growth estimates.

- A broader slowdown in the IT services market. Nearly all services companies have faced slowdown in growth rates in the past two quarters. The reasons for the slowdown have varied across companies depending on exposure to verticals, geography or service offerings. However, the inevitable conclusion is that growth is moderating. We suspect this is on account of broader slowdown in spending though this is yet to show up in industry analysts' IT spending growth forecasts.

- No uptick in financial services spending. Beginning of the year indications pointed to a favorable environment-expectations of increase in interest rate and easing of certain regulations, for acceleration in banking spends. Some of the conditions have been met, but this has not translated into increase in spending. Indian IT is possibly pinning its hopes of conversion of optimism into spending from Sep 2017 quarter though hopes of a back-ended recovery carry significant risks of going wrong.

- Shift to client captives continues. One concern of Indian IT has been continued use of captive centers or insourcing over the 12-18 months. This is driven by a variety of factors-(1) belief that budgets are large enough to drive economies of scale, (2) building up of digital capabilities in house and (3) some level of perceived disappointment on the level of automation and cost savings provided by Indian IT. The pace of captive shift and insourcing is yet to moderate based on our checks.

- Timing difference in capturing digital opportunities. Digital opportunities are large and undisputable. However, many opportunities and spending allocations are still in digital strategy and consulting heavy phase. This leads to lower participation rate in discretionary spending. The size and magnitude of opportunities will increase as digital moves to integration phase even as the timing of the transition remains unclear.

- Partnership landscape being redefined. The big-3 consulting firms and big-4 accounting firms are playing roles of influencers in digital initiatives and have flourishing digital consulting practices. Deloitte in particular has emerged as a leading player in digital. The size and scale of digital practice of these players is not known, but it is reasonable to say that many new players are participating in digital opportunities and clients are comfortable and getting used to working with a number of players/specialists in digital projects.

Many of the growth challenges have existed in the past; but the synchronized impact of the negatives has pulled down growth rates.

How does this translate into numbers?

We forecast organic constant currency revenue growth rate between 4 and 8.5% for Tier 1 companies in our coverage universe. Growth is likely to remain modest till such time as IT spending increase materializes across a broader set of verticals or contribution from digital increases to a reasonable portion of overall revenues. Nasscom indicates that digital revenues will be between 15 and 20% of industry export revenues. Recovery in any case will be uneven, with companies which invested in digital services the only ones that will have revival in growth rates in future.

Do not expect a recovery for all players

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.

Source : Equity Bulls

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