Technology: 1QFY18E Preview - Kotak

We expect Tier 1 IT companies to report muted growth in a seasonally strong quarter due to lack of much anticipated financial services kicker and slower pace of large deal closures. Margin headwinds exist from Rupee appreciation and wage revision. Infosys will have the highest and Tech Mahindra the weakest growth on organic c/c basis in the quarter. Valuations of a few stocks are attractive backed by strong free cash flow yield.

Modest revenue growth, c/c tailwind of 30-80 bps and EBIT margin decline

We expect c/c organic revenue range of 2.8% decline to 2.6% growth. We expect Infosys to lead on organic growth and expect weak performance from Tech Mahindra among large names. This quarter will have cross-currency tailwind of 30to 80 bps. Growth for companies will be weaker than usual in a seasonally strong quarter which we attribute to - (1) lack of acceleration in spending among large banks in US, (2) continuation of small and consulting-heavy digital deals. There have been a few instances of large integrated deals but those are not enough to move the needle and (3) muted pace of deal closures.

EBIT margin to be impacted by Rupee appreciation, visa costs and wage revision

Three specific headwinds will impact performance-(1) Rupee has appreciated by 3.5% against USD and will impact EBIT margins by 50 to 90 bps after considering cross-currency tailwinds, (2) even as the absolute number of visa applications are lower than the previous year, visa application fees will still flow through the P&L and impact EBIT margin on sequential comparison and (3) wage revision-wage revision will be muted and at mid-single digits at best. TCS and Wipro have continued with a normal wage revision cycle while Infosys has deferred it. The combined impact of these headwinds will result in 40-130 bps sequential decline in EBIT margin for large companies. On yoy comparison, EBIT margin decline will range from 50 to 100 bps

Guidance to be retained by Infosys and HCLT

We expect Infosys to retain revenue growth guidance of 6.5 to 8.5%. Achieving the guidance band requires CQGR of 2.1 to 2.9% over 1Q-4QFY18 Based on 1QFY18E performance, achieving upper end of the guidance band seems difficult; a more realistic expectation would be between 7 to7.5%. HCLT has guided for 10.5 to 12.5% c/c revenue growth rate. On organic basis the revenue growth guidance stands at 6 to 8%. We expect Infosys and HCLT to maintain EBIT margin guidance band of 23 to 25% and 19.5 to 20.5% for FY2018, respectively.

Key areas to watch-BFS demand, pricing pressure, large deals progress and automation

We expect investor focus to be-(1) BFS demand, a segment that showed promise in the beginning of the year but failed to follow up through increased spending, (2) large deals progress. Instances of delay in decisions have impacted pace of closures, (3) pricing pressure is known; what is uncertain is the magnitude to which this pressure will be offset through automation and (4) finally, transition of digital projects to the integration phase from the current consulting-heavy phase will determine the magnitude of the Indian IT's participation in discretionary spending.

Capital allocation-returning excess cash is a positive

Indian IT has taken steps in the past three months to return part of the excess cash to shareholders. This shall help improve RoE and defend multiples. Indian IT is available at FCF yield of 5 to 8%. Companies that are able to manage the current transition can deliver substantial returns

We do note that Indian IT has seen slowdown in growth rates in the past though the synchronized sequence of negatives have meant slowdown in growth rates that is more than usual. 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. TCS stock price correction has also made it more interesting in our view.

Comments on individual companies

- Infosys. We expect c/c revenue growth of 2.6%. C/c tailwind seems muted at 10 bps since Mar 2017 quarter revenue included US$9 mn hedging gain which we have assumed will not recur in June 2017 quarter. We expect EBIT margin to decline due to - (1) Rupee appreciation, (2) previous quarter included 30 bps benefit of revenue hedging which we have not modeled for June 2017 quarter and (3) visa costs. Infosys will likely retain 6.5 to 8.5% revenue growth guidance for FY2018. We expect investor focus on (1) demand environment across verticals especially in financial services, (2) TCVs, an area where the company has slipped recently, (3) reasons for continuing attrition at senior management level, and (4) pricing outlook and progress on automation.

- TCS. We expect constant currency (c/c) revenue growth of 2.4% and cross-currency tailwind of 80 bps. The growth is weaker than usual and impacted by soft BFS in North America and industry wide challenges in the Retail vertical Expect EBIT margin to decline on the back of Rupee appreciation and impact of wage revision. This impact can be offset to some extent through lower variable compensation payout. At a broader level we expect investor focus on (1) BFS demand outlook (2) progress on large deals in the insurance vertical, (3) TCS' positioning in the evolving digital landscape and growth outlook for digital practice, and (4) margin outlook in the light of increasing headwinds in the business, Rupee appreciation.

- Wipro. We expect c/c revenue decline of 80 bps as compared to guidance of revenue decline of 0 to 2%. We expect steadier performance from top 10 clients. Recurring EBIT for Mar 2017 quarter was 17.6% though this number was pulled down by impairment charge related to HPS acquisition. On a recurring basis EBIT margin decline is on account of (1) wage revision effected from Jun 2017 and (2) Rupee appreciation. Expect c/c revenue growth guidance of 1-3% for Sep 2017 quarter. Wipro expects to converge with industry growth on a sequential basis in 2HFY18. We expect investor focus on (1) Efficacy of measures taken to improve sales effectiveness, account mining and to defend shares in core areas of competence. Growth from top 10 accounts and increase in US$100 mn+ clients will be closely tracked, (2) integration progress on various acquisitions, (3) outlook for healthcare vertical and HPS acquisition in view of developments in US, and (4) measures taken to defend share in core areas of competence i.e. IMS, PES and BPO.

- HCLT. We expect c/c revenue growth rate of 3.2%. We expect contribution of US$30 mn (1.6%) from full quarter consolidation for Geometric (versus 1 month in Mar 2017 quarter) and IBM IP IV deal. We expect HCLT to retain c/c revenue growth guidance of 10.5 to 12.5%. In addition, we believe that HCLT will retain 19.5 to 20.5% EBIT margin guidance. We expect investor focus on (1) progress in deal closures in IMS, an area where the company cited delays in March 2017 quarter , (2) deal closures in ERD, an area which has witnessed slowdown, (3) how the company intends to catch up with competition in digital, and (4) M&A strategy in the light of multiple acquisitions announced by the company.

- Tech Mahindra. The company will have a disastrous quarter. Expect c/c revenue decline of 1.3% and organic c/c revenue decline of 2.8%. Contributing factors include-- (1) US$12 to 13 mn revenue decline from Comviva, (2) continued pain in LCC and impact of BASE deal ramp down, (3) previous quarter Enterprise segment revenues were boosted by systems integration projects. Expect HCL acquisition to contribute US$17 mn to quarterly revenues. March 2017 quarter had a non-recurring charge of 180 bps from a LCC client contract termination. Despite this we do not expect any sequential improvement in EBITDA margin due to (1) seasonal dip in Comviva margins, (2) Rupee appreciation impact of 60-70 bps and (3) visa costs. We forecast gain of US$20 mn from profitable hedges entered in the previous quarters. We expect investors to focus on (1) roadmap for improvement in margins, productivity and automation, (2) turnaround strategy for LCC and Comviva (3) pricing outlook from top accounts , and (4) growth outlook for top telecom accounts.

Source : Equity Bulls

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