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IT Services Q1FY19 Review - Margins drive upgrades. Commentary better

USD Revenues of IT services companies within IDFC universe posted 1% QoQ and 8% (YoY growth) due to cross currency headwinds. The USD performance was inline with expectation but EBIT margin performance was better than expectations as wage hikes were offset by INR weakness and efficiency gains. In rupee terms, EBIT grew 4%/16% QoQ/YoY and adjusted PAT grew 3%/14% QoQ/YoY. Mid-caps outperformed large-caps during the quarter reporting 18% YoY growth in revenues and 36% YoY growth in reported PAT, led by margin expansion .The quarter saw good growth recovery in the US geography (3% QoQ, &.6% YoY) while Europe’s sequential growth moderated – largely due to currency impact. Companies continued to push efficiency, as headcount grew at 3% YoY, on continued improvement in utilization. Large deals wins were strong across players with digital growing faster than the rest of the businesses. We saw earnings upgrades in the quarter largely on account of margin beat and delivery from Indian IT has been keeping pace with rising expectations. Maintain our constructive view on the sector.

Key findings from Q1FY19 results

Q1 revenue performance inline, margins ahead of expectations: On an aggregate basis, our coverage reported better than expected performance with revenue/Rs-EBIT/Rs-PAT growth of 5%/4%/3% QoQ and 13%16%/14% YoY. IT services companies within our coverage posted strong EBIT margins, up 39bps QoQ/ 95bps YoY helped by INR weakness. Mid-caps such as MTCL/MPHL witnessed revenue and margin-led EBIT beat. Americas as a geography showed some signs of recovery, while BFSI and retail revenue growth were mixed across companies.

Strong commentary on deal flow and BFSI: Even though companies reported mixed BFSI growth, most IT players were optimistic on large deal wins. Exhibit 26 presents statements by IT companies that indicate strong deal momentum and demand acceleration. BFSI, with 6% growth YoY, is expected to see improvement based on deal commentary. During the quarter, TCS signed ~50% of the TCV in BFSI. For Infosys, 40% of large deals were in BFSI. US, in Q1FY19.

Companies continue to push for efficiency: Aggregate headcount of companies within our universe rose 3% YoY. However, utilization across the sector continued to rise by 200-400bps YoY, supporting margins. The net addition has picked up - net addition of 18,672 employees in Q1FY19, compared with 6760 in Q4FY18. This indicates that likely companies are topping out on utilization as a lever. Attrition was steady at TCS but inched up for Infosys, With most companies now operating at 80%+ levels (except MTCL-74%), the same may not be available as a margin lever, going forward.

Earnings upgrades supporting valuations: We think that growth acceleration visible in large cap & mid-caps but still think that revenue beat is led by strong customer specific outperformance. We have seen EPS upgrades across over coverage post this quarter, primarily driven by EBIT margin beat. While companies continue to delivery on earnings which is supporting valuation premium; we think valuations in select mid-cap pockets are demanding. Any further re-rating needs a more secular revenue recovery led upgrades. We stay selective and prefer large-caps and maintain Outperformer on Infosys, TCS and TechM.