FREE

Initiating coverage: IT Services - Set for a cyclical recovery with attractive valuations

Our Overweight (OW) view on the sector hinges on: 1) growth slowdown, which we believe is not entirely structural (has cyclical factors at play), 2) cyclical factors, which impacted growth by 2-3% YoY in FY18E and is bottoming, 3) low earnings expectations and 4) reasonable valuations. We believe Indian IT industry is turning more cyclical, and thus it is unfair to attribute the entire growth moderation to ‘commoditisation’ of legacy technology alone. While we see a drop in legacy, selectively Indian IT could see growth recovery from current low-mid single digit to high single/low double-digit, led by cyclical factors (US BFSI spending) and industrialisation of new technologies. On the other hand, valuations factor in prolonged muted tech spending. We recommend large cap cyclical plays, Infosys and TCS as our top picks and Mindtree as a micro growth story.

Growth slowdown in Indian IT sector is not entirely structural: The broader street has resigned to the fact that growth moderation in the IT sector is entirely structural, attributed to shift in technology. We partially agree, but believe that higher market share has made growth in Indian IT more cyclical. A structural technology shift led slowdown should be broad-based but our findings are to the contrary. Except in select verticals, the sector continues to report healthy double-digit growth.  

Players with higher BFSI and Retail impacted more: Our vertical specific analysis of aggregate revenues of TCS, Infosys, Wipro and HCLT reveals that except in Retail and to an extent BFSI (mostly US Tier I banks – seen from Top10 account performance), there hasn’t been growth moderation in last two years. Retail has been the weakest, as it slid from double-digit growth to flat to negative in over a year.

Street dubbing all structural has led to valuations turning attractive: Consensus expects growth to remain steady with no cyclical recovery in FY20E, valuations across the sector look reasonable at 13x-15x FY19E earnings. We expect growth to improve, once cyclical headwinds abate; and improving US economy and tax reforms return spending from US banks. Additionally, management commentary from large-cap IT players point to bottoming out of spending cuts in the retail industry.

Play Infosys and TCS on cyclical recovery; Mindtree on micro growth: We base our stock selection on: a) cyclical recovery plays and b) micro growth stories. Infosys (OP) and TCS (OP) have been most impacted by weakness in the US BFSI and retail segments and could benefit from cyclical recovery. Infosys is best as a cyclical play and management stability (new CEO) should see improved execution. Within the micro growth stories, we like Mindtree (MTCL) and MphasiS (MPHL) but prefer MTCL for superior EPS growth. We like TechM as a tactical play, as we expect margins to rebound from historic low levels on better execution.