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Event update: IT Services - Takeaways from interaction with TCS and Infosys

Takeaways from interaction with Infosys and TCS

We interacted with TCS and Infosys:

Common trends: 1) Caution in capital markets and Europe manufacturing 2) Possibility of client hesitance in UK, though no cut backs yet and 3) outlook of margin improvement from 1Q levels.

Divergences: 1) Caution at TCS on growth, versus greater confidence at INFO on demand 2) Pushback in retail at TCS, versus no incremental deterioration highlighted by INFO 3) Indications of inline with company growth in BFSI at INFO versus possible moderation at TCS and 4) Divergent commentary in life sciences, with INFO indicating weakness while TCS indicating continuation of strength.

Our view: INFO has outperformed TCS by ~9% over the last 6 months and we expect this outperformance to continue on 1) Better growth, with easy asking rates and possibility of a guidance upgrade in FY20 2) likely lower EBIT margin fall over FY19-22E at 120bps (vs 170bps at TCS), on our estimates and 3) valuations at a discount of 13% to TCS. Historically, when TCS and INFO growth have equalized valuations too have converged, even though from a 5 year average perspective INFO has traded at a ~18% discount to TCS. We retain Outperformer on INFO and Neutral on TCS. Sharper than expected margin increases at TCS or any incremental client specific issues at INFO are key risks to our call.   

TCS takeaways:

Cautious on demand in BFSI, Europe manufacturing and sees pushback in recovery in Retail: TCS indicated that newsflow has worsened since July and highlighted 1) caution in BFSI driven by capital markets, 2) likely pushback on recovery expectations in retail versus 2Q earlier, driven by client specific issues in US and 3) weakness in Europe manufacturing, driven largely by auto. Though US auto is holding up with strength in tier 1 suppliers and OEMs. The company believes BFSI demand moderation is more a sector issue, while retail issues are more client specific in nature. With retail sector in an existential need to spend to transform, recovery would be driven by spending at other clients on digital initiatives. In, BFSI while till now capital market is affected and not banking, but if the current negative yield scenario continues impacts here too cannot be ruled out. In capital markets, the pressure is more on run the business spends, even as new business pipeline is healthy.

Insurance platform deal pipeline strong but timing of deal wins is uncertain: TCS benefited in FY19 from ~USD5bn in deal wins in the insurance platform deal space, with deals like M&G Prudential, Transamerica and Scottish Widows. It indicated that these are long gestation deals and while pipeline is strong conversion timeline is uncertain. This business has been UK and US centric for TCS.

Expects steady demand trends in telecom and strength in life sciences: The company sees steady demand trends in Telecom and continued strength in life sciences (which has been growing at mid to high teens over the last 4 quarters). In life sciences, the company has a strong play in the drug discovery phase with its IP and other IT Services are gravitating towards it on account of this fact. In telecom, the demand is driven by business becoming more subscription based and this leads to the need for better customer experience, which is driving IT demand. 5G according to TCS has seen slower rollout and should see expanding opportunity over the next 3-5 years, with likely strong demand driven by network management and follow through demand in the enterprise use cases for 5G. Demand during the rollout phase of 5G is unlikely to be substantial.

Double digit growth looks difficult: With 1Q seeing progressive weakening, similar sluggish trends in BFSI continuing and pushback on retail recovery, double digit growth looks difficult. Further, there could be an impact on FY21 growth if the exit is weak.

Irrational pricing seen in the traditional outsourcing: In the traditional outsourcing side, there is some level of irrational pricing been seen from players whose avenues for growth are limited or their propositions are weaker on the digital side.

Target to return to the 26% range on EBIT margins: TCS posted EBIT margins of 24.2% in 1QFY20 and is targeting to return to its stated band of margins. While the company rules out any aggressive cost cuts, as it could be counterproductive in the current demand environment, but it would look at optimizing costs across its 150 P&L units. In terms of key parameters 1) INR depreciation should aid margins (though the offset from adverse cross currency moves will have be assessed) 2) Sub-contracting and localization could continue to rise, as the company has applied for lesser number of visas 3) SGA is optimized at 15.8% levels (near historical lows) largely driven by utilizations and 4) hiring could continue, with the company having made 30,000 fresher offers at the start of FY20. We believe some level of optimization on margins cannot be ruled out in a scenario of incremental moderation in demand outlook.

Capital return: TCS has a stated capital allocation policy of paying out 80-100% of free cash flow to shareholders. It is agnostic to whether it is through dividends or buybacks.

Infosys takeaways:

Sounding confident on demand: The company indicated that other than already highlighted issues in capital markets, regional US banks due to M&A, some parts of life sciences and Europe manufacturing they have not seen any incremental moderation in demand or changes in client spending patterns. The company see strong momentum driven by deal wins, good pipeline and expects its largest vertical (BFSI) to perform inline with company guided growth (8.5-10% in FY20). In comparison to TCS which has indicated pushback in retail recovery, INFO indicated no incremental weakness. It sees Retail as a mixed bag with pockets of weakness at a few clients, but countered by push to expand digital footprint at others. Within BFSI, the company sees demand strength in areas like cards, payments and insurance.

Reiterates guidance of 8.5-10% CC growth in FY20: The company reiterated its guidance of 8.5-10% growth in FY20. On our calculation, INFO CQGR requirement to meet top end of its guidance is ~1.5% over 2Q-4Q (ex of contribution from Stater), which is not steep and we see a possibility of a guidance raise and build 10.3% y-y growth in FY20. The company was non-committal on possibility of a guidance raise, but indicated that as they get more certainty they would look to update their guidance. 

Hesitance, but no cutbacks in Europe: The company indicated that there is some confusion among clients in Continental Europe/UK, but it has not seen any instances of a cut back. However, for demand to improve clarity needs to come on Brexit.

Reiterates FY20 EBIT margin guidance of 21-23%: INFO reiterated its confidence on its FY20 margin guidance. The levers according to the company are 1) reversal in visa costs (up ~80bps q-q in 1Q) 2) Likely increases in utilization (currently ~180bps lower than historical peak) 3) currency depreciation 4) Possibility of gradual reduction in sub-contracting costs as % of sales as local hiring and fresh graduate hiring substitutes high cost sub-contractors. The company has applied for higher number of visas in FY20, hired its targeted 10,000 people in US and its sub-contracting costs have been flattish in % of sales terms over last 3 quarters. According to the company, wage hikes impacts in 2Q should be lower than in 1Q, as it is largely applicable for mid-level employees, even as bulk of its employees have been covered in 1Q. In 3Q the company is likely to see wage hikes for its senior employees. With wage hikes not being an incremental margin depressant, reversal of visa fees and INR depreciation benefits, the company could be back in its guided range of 21-23% in 2Q in our view (vs 20.5% in 1Q).

Attrition largely in 3-5 year experience bracket: INFO indicated that majority of its attrition is in the lower experienced staff (3-5 years), with low attrition in the middle or senior level.  1Q attrition was at 23.4%, partly elevated due to seasonality in 1Q, but the company expects a reduction gradually.

Capital return: INFO stated capital allocation policy is to pay out 85% of its free cash flow to shareholders.