IT Mixed quarter, remain selective Sector Update During April-June 2019 quarter, tier-1 Indian IT companies clocked Q1FY2020 Results Review mixed revenue growth, while EBIT margins declined across companies Sector: IT Services sequentially. Constant currency (CC) revenue growth for TCS, Infosys and HCL Tech remained strong at 10.6%, 12.4% and 17%, y-o-y Sector View: Neutral respectively. HCL Tech impressed with strong CC revenue growth of 4.2%, led by large deal ramp-ups, while TCS and Wipro missed our revenue estimates on soft growth in the BFSI vertical, as was the case with many other IT firms as well. However, most companies saw strong deal wins continue and a higher digital market share along with robust Our coverage universe y-o-y growth. Except TCS, elevated attrition remained a concern for most of the companies. Margins declined owing to wage revision, a rise CMP PT Companies Reco. (Rs) (Rs) in visa costs, transition costs for large deals, subcontracting costs and a stronger rupee. Most companies broadly maintained revenue growth HCL Tech 1,078 Buy 1,250 guidance for FY2020E, except Infosys, which raised its guidance despite a weak macro environment. Infosys 795 Buy 840 Outlook: L&T Infotech 1,593 Positive 1698 Cautious outlook on BFSI amid macro uncertainties, maintain Neutral L&T Tech 1,573 Positive 1847 stance: As spending by clients with exposure to capital markets Mastek 316 Positive 513 (especially in the US) and large European banks moderates and falling Persistent 564 Hold 650 interest rate in North America, we believe that growth in the BFSI vertical will remain weak in FY2020E. Further, slower demand owing to weak TCS 2,215 Buy 2,300 macroeconomics, trade wars and Brexit could delay client decisions Tech M 683 Positive 755 on spending. However, strong deal wins, a healthy deal pipeline, new Wipro 252 Hold 285 logo wins and robust growth in the digital segment offer us some comfort on sustainability of revenue growth momentum in FY2020E. The managements of most IT companies largely maintained revenue growth guidance (excluding Infosys) for FY2020E, though the growth outlook for TCS and Wipro depends on Q2 revenue growth, which would compensate Price chart any shortfall in a seasonally weak 2HFY2020E. Margins are expected 120 to remain under pressure owing to higher attrition, shortage of talent, transition costs in large deals and intense competition. Given cautious 110 commentaries on the BFSI and manufacturing verticals, higher attrition 100 and constraints in talent supply, we stay Neutral on the IT sector. 90 Valuations: 80 Macro unsupportive, remain selective: The CNX IT index has moved up 19 18 19 18 19 18 19 - - - - - - - Jun Oct Apr Feb Dec Aug Aug by around 3% in the past one year and outperformed the Nifty by 9% in Nifty IT Nifty the same period. The steady performance by the CNX IT index was led by a stable demand environment, strong deal wins and the rising share of the digital segment. TCS continues to trade at a premium valuation on account of its strong business model and superior execution capabilities. HCL Tech and Tech Mahindra are trading significant discount to large peers due to certain challenges in their business models. Stock prices of most mid-cap IT companies have corrected in recent months on slowing revenue growth momentum and company-specific issues. Though we believe margins would remain under pressure, the rupee depreciation could be a wild card from margin tailwind. We continue to prefer select stocks in the IT sector given the potential revenue growth acceleration and reasonable valuation. Key risks: 1) Rupee appreciation vis-à-vis USD would affect earnings estimates in FY2020E/FY2021E and stock performance, 2) weaker macros including a potential for slower GDP growth in the US, Trade wars and Brexit and 3) continuation of elevated attrition. Leaders in Q1FY2020: HCL Tech and Infosys Laggards in Q1FY2020: Persistent systems & Mastek Preferred picks: Infosys, HCL Tech and Tech M among large-cap companies; L&T Infotech, Mastek & L&T Tech in the mid-cap space. August 22, 2019 2 Sector Update Q1FY2020 results snapshot Revenue q-o-q y-o-y EBITDA EBITDA q-o-q y-o-y Net q-o-q y-o-y (Rs cr) (%) (%) (Rs cr) margin (BPS) (BPS) profit (%) (%) Company name (%) (Rscr) HCL Technologies 16,425.0 2.7 18.4 3,400.0 20.7 -180 -254 2,220.0 -13.6 -7.6 Infosys 21,803.0 1.2 14.0 5,152.0 23.6 -28 -237 3,802.0 -6.7 5.3 Persistent Systems 832.1 0.0 -0.3 120.2 14.4 -77 -234 82.5 -2.4 -5.6 TCS 38,172.0 0.4 11.4 10,037.0 26.3 -21 -18 8,131.0 0.1 10.8 Wipro 14,716.1 -2.1 5.3 2,947.0 20.0 -186 80 2,387.4 -3.9 12.6 Soft coverage (Viewpoint) L&T Infotech 2,484.9 0.0 15.3 457.9 18.4 -74 -101 355.5 -6.1 -1.6 L&T Tech 1,347.5 0.3 17.0 272.7 20.2 177 322 203.9 6.5 3.2 Mastek Limited 247.5 -7.3 1.4 32.9 13.3 7 60 24.2 -9.8 7.8 Tech Mahindra 8,653.0 -2.7 4.6 1,314.1 15.2 -324 -425 959.3 -15.3 6.8 Source: Company, Sharekhan Research Valuations Price CMP EPS (Rs) P/E (x) Particulars Reco target (Rs) (Rs) FY19 FY20E FY21E FY19 FY20E FY21E HCL Technologies Buy 1,250 1,078 73.6 76.7 84.6 14.7 14.0 12.7 Infosys Buy 840 795 35.4 38.1 43.6 22.4 20.9 18.2 Persistent Systems Hold 650 564 44.0 48.4 52.5 12.8 11.7 10.7 TCS Buy 2,300 2,215 83.1 89.9 98.7 26.7 24.6 22.4 Wipro Hold 285 252 14.9 16.4 18.2 16.9 15.3 13.8 Soft coverage (Viewpoint) L&T Infotech Positive 1,698 1,593 86.4 84.8 98.9 18.4 18.8 16.1 L&T Tech Positive 1,847 1,573 72.9 75.7 86.4 21.6 20.8 18.2 Mastek Limited Positive 513 316 40.1 43.9 51.3 7.9 7.2 6.2 Tech Mahindra* Positive 755 683 47.7 50.2 56.9 14.3 13.6 12.0 Source: Company, Sharekhan Research *EPS of Tech Mahindra excludes treasury shares August 22, 2019 3 Sector Update Key points Mixed revenue performance: In Q1FY2020, tier-1 Indian IT companies reported mixed revenue growth performance, with revenue rising by -1.8-3.8% q-o-q and 0.6-15% y-o-y in US Dollar terms. However, on a y-o-y basis, tier-1 IT companies delivered strong constant currency (CC) revenue growth of 5.9-17% in Q1FY2020. CC revenue growth for Infosys and HCL Tech continued to accelerate y-o-y, while it decelerated for TCS, Wipro and Tech Mahindra (Tech M). TCS’ y-o-y revenue growth remained robust at 10.6% in Q1FY2020. HCL Tech impressed with a strong CC revenue growth of 4.2% q-o-q led by large deal ramp-ups and a lower-than-expected ramp-down from a couple of clients in the financial services vertical and one client in the manufacturing vertical. Infosys and Tech M reported revenue growth on expected lines, while TCS and Wipro missed our revenue expectations owing to soft growth in the financial services vertical. HCL Tech continued to lead the pack with CC revenue growth of 4.2% q-o-q (3.7% organic) during Q1FY2020, followed by Infosys (2.8% q-o-q), TCS (2.2% q-o-q), Wipro (-0.7% q-o-q) and Tech M (-1% q-o-q). Under our mid-cap coverage, L&T Infotech (LTI) delivered revenue growth on expected lines, while L&T Tech (LTTS), Persistent Systems (PSL) and Mastek delivered lower-than-expected revenue growth numbers. Margins under pressure: In Q1FY2020, margins remained weak. EBIT margin of tier-1 IT companies declined on a q-o-q as well as y-o-y basis for most companies (except Wipro). Pressure on operating profitability can be attributed to higher subcontractor expenses, seasonality (wage hikes), higher visa costs, transition expenses on large deals and rupee appreciation. Under our mid-cap coverage, L&T Tech (LTTS) surprised with beat in margin estimates, while LTI and Mastek clocked an operating profit margin (OPM) on expected lines. We expect margin pressure to continue in FY2020E on account of higher attrition, investments for future growth and constraint in talent supply. BFSI stays soft, attrition rates soar, deal wins stay strong: Managements most of tier-1 companies indicated that revenue growth was affected by weakness in the BFSI (capital markets in the US and European banking clients), manufacturing vertical and lower spending of clients in key regions. Cognizant’s management remained cautious on spends in the banking sector in H2 due to weakness in capital markets, M&A activity in the US and weak macro factors. Most IT companies highlighted strong deal inflows and healthy deal pipelines during the quarter. Deal wins increased by 16-123% y-o-y for the top five companies, reflecting a good demand environment. Digital revenue grew strongly across companies (except PSL) and the contribution to overall revenue improved to almost one-third (29.7-38.9%) in Q1FY2020.