Will worsening macro indicators start reflecting in commentary? We expect Tier 1 IT (information technology) (incl. Cognizant Technology) aggregate USD CC (constant currency) revenues to grow marginally below Q1 at 3.4% q-o-q (quarter on quarter) in Q2F (vs 3.7% q-o-q in Q1) and overall USD revenue growth to decelerate to 9.5% y-o-y (seventh quarter of deceleration from a peak of 15.4% y-o-y). Cross currency moves will again hit USD revenues by 80-100bps across tier 1 IT (ex Cognizant). In CC terms, TCS and Infosys will likely lead growth (4% q-o-q), followed by HCL Technologies (3.3% q-o-q) and Cognizant/Wipro (2.7% q-o-q). Tech Mahindra will lag with 2% q-o-q in CC terms, in our view. The key to watch is whether there is any tempering of growth expectations going forward, given contrasts of positive demand commentary and weakening macro indicators. Also of interest would be: (i) trends in US/BFSI/Retail/ADM/EAS, which have been laggards; (ii) commentary on challenged segments Energy/Telecom; and (iii) continuation of strong momentum in Europe/IMS/BPO/Engineering services/Mfg/Healthcare.
Will larger segments – US/BFSI/Retail – rebound?
We believe there has been some worsening of macro demand indicators (US PMI down to a 12-month low in Aug-15, private jobs data being weaker than last year, and client financials seeing deterioration over the last three-four quarters). This seems to have weighed on US growth for Indian IT, in addition to sector-specific issues in energy/telecom. Recovery in the US is crucial for stock performance and we believe those hopes could see some tempering going into 2H as the weaker macro feeds into demand. Commentary on (i) BFSI/Retail, which have been the key contributors to US drag, and (ii) Continuation of traction in Europe will be keenly watched.
Will pricing stabilise and INR depreciation benefits be retained?
Historically in sharp rupee depreciation periods, margin impacts have been between one-fifth to half of theoretical impacts, and whether rupee depreciation gains will be retained this time around will be key to countering any growth moderation. The answer to that would lie in pricing trends, which we think might continue to be soft. Our view is that while Q2 will see margin increases driven by INR depreciation, these benefits are unlikely to be retained going forward. We expect Ebit margins at HCL Tech to be up 60bps q-q, TCS/Infosys up ~90bps q-o-q and Tech Mahindra up ~200bps q-o-q. At Wipro, we expect flattish margin trends as USD-INR realisations in Q1 were high at 64.7. The aggregate earnings growth for Tier-1 IT is likely to be at ~12.5% y-o-y in Q2FY16F (forecast), on our estimates.
Key things to watch:
Infosys: We expect Infosys to retain its FY16F USD CC revenue growth guidance of 10-12%. Key to watch would be (i) Pricing trends and any stability (after ~700bp CC offshore pricing decline over last four quarters), (ii) deal flow and deal win commentary, and (iii) Sustenance of Q1 performance in Consulting & SI and improvement in ADM (together ~two-thirds of Infosys revenues), will be a trigger for re-rating. Any moderation in commentary on margins, or back-ended growth indications, might be taken negatively. We believe that while near-term growth expectations might not be at risk, there is a chance of a disappointment with respect to Street Ebit margin expectations.
TCS: TCS for the past four quarters has come in below consensus revenue growth expectations, driven by segment-specific weakness in energy/telecom /insurance or geographical weakness in Japan/LATAM/India, and this has led to the stock underperforming the Nifty by 2% LTM (last twelve months). We believe an in line or better result is crucial in Q2 for stock performance, even though we consider TCS to be fundamentally stronger than Infosys/Wipro.
Wipro: We expect Wipro to guide for 1.5-3.5% q-o-q USD revenue growth in Q3FY16F. The key catalyst for Wipro would be better growth in Europe (which has dragged at -4% y-o-y in LTM vs ~4% y-o-y for tier 1 IT aggregate), the rebound in Healthcare (seen two quarters of softness after growing strongly) and any signs of stabilisation in Energy & Utilities. Commentary on Energy & Utilities (Wipro’s area of strength) and possible second half recovery, as indicated by the company earlier, would be keenly watched.
HCL Tech: We expect strong momentum in IMS and BPO at HCL Technologies, although engineering services could possibly take a breather after ~23% y-o-y growth in FY15 (though we remain positive on longer-term prospects). We expect positive margin progression despite partial salary hikes in Q1, which should give comfort on management guidance of FY16F Ebit margins between 21% and 22%. Growth comfort and reasonable valuations should continue to be the drivers for stock performance.
Cognizant: We expect Cognizant Technology to marginally raise its FY15F guidance to 20.5%+ (vs 20.1% earlier). Strength in healthcare and near-term impacts of M&A in this space, coupled with share gains in BFSI, would be key to watch. We believe Cognizant is well-placed on growth given ~ 50% revenue contribution from manufacturing and healthcare, market share gains in BFSI, and strong Digital Capabilities.
Tech Mahindra: Tech Mahindra would be the weakest result on growth among tier 1 information technology in Q2, on our calculation. However, margin trajectory should start to improve, the slope of which along with the outlook on telecom/enterprise segments and deal flow will be keenly watched. Play selective; back growth comfort; top Buys HCL Tech and Cognizant.
Mix is becoming important in choosing stocks as contrasting forces are at play (i) US demand has not seen improvement, while Europe is strong at constant currency growth of 16% y-o-y for tier 1 IT; (ii) traditional services (ADM/EAS) are sluggish, while underpenetrated services (IMS/BPO/Engineering services) are strong; (iii) BFSI/Retail are decelerating while healthcare are growing
Given the importance of mix, we prefer HCL Tech (IMS, Engg. Services, BPO ~60% of revenues) and Cognizant (Healthcare/Mfg ~50% of revenues, strong Digital capabilities and market share gains in BFSI) as our key absolute Buys in the space.
Within TCS/Infosys we prefer TCS from a longer-term perspective on a relative basis on better portfolio mix and stronger fundamentals. Though on near-term commentary, Infosys is sounding more confident than TCS.
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