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Reinitiating coverage: IT Services - Relative outperformance likely but in isolation not exciting

We reinitiate coverage on the sector with an Overweight rating. We see IT Services as a defensive play, given the stress in domestic-focused sectors, regulatory hurdles in export-oriented pharma, absence of cash generation, corporate governance and leverage-related concerns. However, our fundamental stance on growth and margins is cautious, as 1) weaker macro translates into slower demand – with US topping out, Europe materially weakening and BFSI/Manufacturing (1/2 of Top 4 revenues) slowing, 2) legacy drag continues, and, 3) competition stays elevated, especially in Digital from consulting-focused MNCs, front end-focussed Challengers, tier 2 IT and insourcing. We estimate 8% USD revenue and 6.3% PAT CAGR for Top 4 over FY19-22E. Valuations are elevated at 20.8x 1-year forward (~18% premium to historical), even as divergences remain. INFO/TCS trade at near peak levels, while the rest hover at average or near bottom multiples. We back value plays, with lower expectations. HCL Tech and Infosys are our top large-cap picks and we like Mphasis and Justdial within mid-caps. Wipro among large caps and Hexaware within mid-caps are our least preferred stocks.

Past outperformance factors weakening; remain defensive: Factors like domestic liquidity, macro tailwinds to growth and ~9% INR depreciation, which drove 37% outperformance in CNXIT versus Nifty over last 2 years are weakening. However, lack of options in rest of the market, expected modest moderation in IT demand versus other sectors and limited balance sheet or corporate governance concerns should render IT as a good defensive bet.

Growth unexciting in isolation; margins could moderate: Our caution on growth comes from 1) mainly BFSI/Manufacturing and Europe, 2) Legacy drag (2/3^rds of business) and Digital likely slowing in percentage terms on base effects and lesser annuity, and, 3) likely replication of slowdown in MNCs (ACN/CAP), Challengers (EPAM/VRTU/GLOB) and tier 2 IT, at Top 4. Margin caution is on 1) limited utilisation scope, hiring converging with revenues and limited selling, general and administrative (SG&A) leverage, 2) supply-side issues and legacy drag. EBIT margins could fall 130bps to 21.3%, with PAT growth moderating from 16% in FY19 to 3% in FY20E.

Top picks - HCLT, INFO within large caps and MPHL in mid cap: We recommend playing the sector selectively and focussing on 1) Value plays, where either expectations are low or there are turnaround possibilities (HCLT/JUST), 2) low dependence on external demand (MPHL), 3) Greater surety on growth and possible bottoming out of margins (INFO). We would avoid stocks with weak fundamentals and underperformance on growth (WPRO). We are Neutral on TCS, given weak near-term outlook and expensive valuation. We like INFOE but await a better entry point.