Best Stocks In Information Technology Sector

Peaking Global Capex Cycle; ‘Relatives’ Are The Only Positives

We continue to remain ‘tactically’ positive on the Indian IT services sector despite the 33pps outperformance of Nifty IT vis-à-vis Nifty CYTD 2018. However, our arguments for continued outperformance have changed since March 2018 when we turned positive on the sector (Turning Tactically Positive) after having been negative since April 2015.

Our change in stance in March 2018 was driven by expectation of a modest (and selective) growth pick-up because of a peaking developed market economic cycle that was boosted by US tax reforms, large underweight institutional positioning in the sector, negative news flow on ‘financials’ (a large overweight sector for institutions) and lastly, better relative valuation (which is less compelling now than it was in early 2018). All of this was supported by robust capital return by some key players in the sector.

We now believe that stocks under our coverage have witnessed a pick-up in growth in FY19 (modest and selective) to a very large extent and are pricing in a modest acceleration in FY20 (something which we are sceptical about – we are in the mid single-digit growth camp, while the majority on the street believe in high single-digit growth). We have been surprised that despite a very robust pick-up in global capex in 2018 (see Exhibits 6 to 13) in both the US and Europe, the uptick in Indian IT services industry growth has fallen below expectations- in terms of strength as well as breadth. The strength part is explained by the fact that Indian IT services share in digital (faster-growing) has been poor because of lack of adequate capabilities in addressing the consumer facing/front-end of customer’s businesses (revolving around digital marketing, customer experience), while a large part of the legacy business is witnessing value compression because of increased use of automation, cloud migration and insourcing.

The lack of breadth indicates that while the Indian industry (in aggregate) is behind the curve in building capabilities, there are some who are relatively better off. The faster growth shown by mid-caps is basically a case of ‘rising tide lifting all boats’, a smaller base and lower exposure to legacy services. But as digital demand shifts from the front to back, we believe that traditional large Indian companies (who have been pivoting to new services) will be in a better position to capture the market. Mid-caps may witness faster earnings growth pick-up on a low base in FY19 (from bombed-out margins in some cases), but would advise investors to focus on sustainability and not overpay for a riskier business model.

We believe the great macro environment of 2018 is unlikely to be repeated in 2019. So why do we persevere with our positive stance for now? That is because ‘relatives’ will all play in favour of Indian IT services sector for some more time – ‘relative’ institutional positioning (DIIs and FPIs), ‘relative’ earnings revision momentum (because we believe the full extent of INR depreciation is not factored into consensus numbers) and ‘relative’ valuation (less so now than 6 months back). We have rolled forward the basis of our valuation from March 2020E EPS to September 2020E EPS (see Exhibit 1 for changes made to our ratings, target prices, target P/E multiples and estimates).

Where we are different from consensus expectations:

(1) We do not believe that underlying revenue growth is seeing a robust pick-up, despite being in the best macro environment for IT services ever since the Global Financial Crisis of 2008-09. For instance, for the very first time in 10 years – in our view – there is selective management commentary indicating that pricing is firm/stable. This coming at the last leg of a positive economic cycle means that industry will face significant pricing pressure – both in digital and legacy services – should economic/revenue/capex growth soften.

(2) While our USD revenue growth assumptions are lower than that of the street, our assumptions on INR/USD are probably the highest, driven by the view taken by our economist Ms.Teresa John in her latest report: Are India’s FX Reserves Sufficient?. The higher than consensus EPS numbers basically stem from these INR assumptions rather than a more constructive view on underlying fundamentals.

(3) We are probably the only Sell side firm which is calling for a decline in the industry in FY21 driven by the view that US economy will probably slow down from current red-hot levels to near stall levels. Consensus, through robust growth assumptions for FY21, implicitly assumes that the US will continue to chug along at a good clip.

(4) While we admit that we missed the monstrous mid-cap upside we continue to remain sceptical in the long run on their prospects, especially with the view we have on the US economy in 2020.

When do we get off this gravy train?:

From this stage onwards, our positivity on the sector is more a portfolio and a relative call rather than a standalone one. Robust global economic growth combined with tight liquidity globally will help the sector initially as the INR depreciates (probably a bit more than what we had anticipated), but there would come a time when the tightness of financial conditions will adversely impact developed market growth, revenue growth for Global 2000 companies, their spending plan and consequently demand for Indian IT services.

We, however, believe that is probably another 12 months away and do not foresee any material negative to develop on the demand front in the next six months. The real risk, in our view, is that elevated revenue growth expectations (in USD terms) for FY20 and FY21 that consensus has are likely to moderate as the capex cools off.

Risks to our view: The upside risks to our stock target prices include:

(1) An economic cycle upturn than lasts longer than we are currently anticipating.

(2) A higher-than-currently expected depreciation of the INR.

(3) A sustained flight away from financials as inflation/interest rates move higher and stressed asset cycle elongates. This ties in with the view that Nifty earnings in FY19 and FY20 are likely to show downward revision while the earnings of IT services sector look up.

Downside risks to our target prices include:

(1) A significant and faster-than-expected slowdown in the US/global economy. The rise in interest rates in the US and trade war with China could be catalysts.

(2) Faster-than-expected return to Indian ‘financials’ as interest rates stabilise and stressed asset provisioning peaks.

Exhibit 1: Changes made to our earnings estimates, target prices and ratings

Company

CMP (Rs)

New rating

New
TP (Rs)

Change
(%)

TCS

2,063

Accumulate

2145

13.8

Infosys

711

Accumulate

752

(43.4)

Wipro

325

Buy

377

16.8

HCL Technologies

1,081

Buy

1,281

9.3

Tech Mahindra

721

Buy

845

17.7

Mindtree

1,057

Sell

986

34.4

Persistent Systems

718

Buy

909

4.9

 


Exhibit 2: Assumptions on macro and companies 2018

2019

2020

Real US GDP growth (%)

2.75-3.25

1.5-2.5

0.0-1.5

FY19E

FY20E

FY21E

INR/USD

72

77

79.7

USD revenue growth (%)

FY19E

FY20E

FY21E

TCS

9.2

8.0

Infosys

6.7

7.9

(0.2)

Wipro (IT services)

2.8

5.4

(3.0)

HCL Technologies

9.4

7.7

0.1

Tech Mahindra

4.7

8.6

(1.8)

Mindtree

18.7

8.1

(1.5)

Persistent Systems

11.2

10.4

0.5

EBIT margin (INR) (%)

TCS

26.3

27.1

27.5

Infosys

24.8

24.8

25.0

Wipro

17.4

18.0

17.7

HCL Tech

20.1

20.0

20.1

Tech Mahindra

14.1

13.9

13.3

Mindtree

13.7

15.7

14.9

Persistent Systems

12.8

13.6

13.2

EPS (Rs)

TCS

87.9

101.5

108.8

Infosys

39.5

44.7

47.4

Wipro

21.3

25.3

26.0

HCL Tech

78.7

88.1

91.0

Tech Mahindra

49.7

57.6

57.4

Mindtree

47.6

64.9

67.7

Persistent Systems

52.6

68.6

71.0

EPS growth (%)

TCS

31.2

15.5

7.2

Infosys

21.4

13.3

6.0

Wipro

26.9

18.8

2.5

HCL Tech

24.8

12.0

3.3

Tech Mahindra

16.2

15.8

(0.4)

Mindtree

37.4

36.2

4.3

Persistent Systems

30.3

30.3

3.6

 

Institutional investors still continue to be underweight on Indian IT services – This is the case both on DII and FII fronts as of June quarter 2018 data, which in our view is going to be a critical technical factor at play as there are no countervailing large liquid sectors as people pare their OW financials positions (see Exhibits 3 and 4) which are going to see some stress because of earnings cuts (both because of lower growth and NIM compression) and valuation downgrade in the wake of higher interest rates. Both DIIs and FPIs seem to have a 350-400bps underweight stance on the sector vis-à-vis key benchmarks.

 

 

 

 

 

 

 

 

 

 

 

 

Exhibit 3: FPIs are overweight on financials versus IT services Industry

 FII %

 Basic Materials

 4.0

 Consumer Goods

 14.7

 Consumer Services

 1.0

 Financials

 38.1

 Healthcare

 4.7

 Industrials

 10.4

 Oil & Gas

 9.8

 Technology

 12.9

 Telecommunications

 2.1

 Utilities

 2.2

 Total

 100.0

 

Exhibit 4: DII are overweight on financials and industrials while underweight on IT services

Industry

DII %

% BSE 200

Basic Materials

9.5

7.25

Consumer Goods

18.7

19.40

Consumer Services

0.9

0.87

Financials

26.0

24.05

Health Care

4.7

5.74

Industrials

14.2

12.21

Oil & Gas

11.1

12.15

Technology

9.6

13.25

Telecommunications

1.4

1.99

Utilities

3.9

3.09

Total

100.0

100.0

 

INR benefits are going to be substantial over FY18-FY21E: Earnings of our Tier-1 universe of stocks had a PAT CAGR of ~6% over FY15-FY18 as USD revenues and EBIT (INR) growth slowed down to mid single-digit (see Exhibit 5). The slow USD growth was compounded by INR/USD depreciation which was much slower at 1.7% during the period against a historical average of 5%-6% since 1947. We now expect PAT CAGR in low teens for the same coverage universe over FY18-FY21E driven by USD revenue growth in mid single-digit and EBIT (INR) growth in mid-teens. This is to a very large extent supported by depreciation of 7% annually in the INR that our economist Ms.Teresa John expects during this timeframe (FY18-FY21E). We are factoring in INR/USD rate of 72/77/79.7 for FY19E/FY20E/FY21E, respectively.

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