The IT sector continues to face disruptive trends in terms of SMAC leading to cannibalisation of revenue

RSec Research recently provided an overview of the state of the Indian IT economy.

We expects the IT firms under the coverage universe to post a combined 3.3 percent QoQ rise in USD revenue in 2QFY18. We expect the top-5 IT firms to post 2-4 percent QoQ USD revenue growth in reported terms (1-3 percent in CC terms), with TCS and HCL Technologies to lead the show.

Mid-sized firms will see variation, with Cyient and Mindtree likely to lead (6.2 percent and 5.6 percent QoQ USD revenue growth, respectively). A positive in 2QFY18 is favourable cross-currency movements, with the USD depreciating against the EUR, GBP and AUD by 2-6 percent, which will positively impact reported USD growth numbers by 60-160bps.

The IT sector continues to face disruptive trends in terms of SMAC leading to cannibalisation of revenue, apart from pricing pressure in commoditised services, and automation. The IT Industry association, NASSCOM projected 7-8 percent growth in IT-BPO exports in FY18, with the announcement coming as late as June 22 as against its traditional practice of providing industry growth guidance in February, owing to global uncertainty. We do not expect the industry to surpass this growth target and believe high single digit growth is realistic in the near-term.

On the margin front, we expect a varied performance among the top-tier IT firms, with TCS, HCLT and Tech Mahindra (TechM) expected to report 40-130bps rise, while Infosys and Wipro are likely to post 70-80bps QoQ decline on wage hike impact. Within our mid-cap coverage universe, we expect Mindtree, Cyient and Persistent Systems to post 35-80bps QoQ increase in margins aided by revenue growth and operational efficiency.

We expect continuous focus on levers like utilisation and cost efficiencies. On YoY basis, with the exception of HCLT, all IT firms under our coverage universe will post declines in the range of 70-630bps.

Looking ahead, we would watch for sustainable margin outlook and IT budget trend. Focus on return of cash to shareholders is also a theme playing out, with TCS, Infosys, Wipro, HCLT, Hexaware, Mindtree and eClerx all resorting to share buy-back in order to make better usage of their cash balances. We continue to believe Indian IT is a bottom-up sector and stock picks will play a key role in driving alpha.

As for the top picks, HCLT is among the large-caps, Cyient and Sonata Software are among the mid-caps. Among others, there is Central Depository Services (CDSL).

Cross currency movements to boost revenue growth
We expect 3.3 percent sequential revenue growth for the IT firms under our coverage universe. On a YoY basis, growth is likely to remain in single digit at 8.3 percent, owing to disruptive trends, increasing competitive intensity and pricing pressure. A positive – one of the few that have aided IT firms in recent times – is favourable cross-currency movements (GBP, EUR and AUD depreciated by 2-6 percent QoQ vs. the USD), which will have a positive impact to the tune of 60-160bps on reported USD growth numbers.

Company-wise, we expect TCS and HCLT to lead among top-tier IT firms. Among mid-sized firms, Cyient and Mindtree are likely to lead. We believe factors like SMAC, challenging macro, high competitive intensity and pricing pressure will sustain and expect these factors to impact growth over the next few quarters.

Mixed trends for margins
We expect a mixed performance on margin front. Among top-tier IT firms, TCS, HCLT and TechM are likely to report 40-130bps rise, while Infosys and Wipro are likely to post 70-80bps QoQ decline owing to wage hikes. Among mid-sized IT firms, Mindtree, Cyient and Persistent are likely to post 35-80bps QoQ increase in margins aided by revenue growth and operational efficiency.

Client specific issues, challenging macro scenario and vertical/service specific headwinds could continue to impact profitability.

In our view, the street’s attention will be focused on revenue guidance/qualitative outlook and optimum cash utilisation. We believe status quo on the first aspect and incremental progress on the second aspect will be viewed as positives, particularly some action on the inorganic growth front. The business environment continues to remain challenging.

Disruptive trends, mainly SMAC are likely to continue to eat away at IT firms’ businesses. In such a context, maintaining margins within a narrow band at least until revenue growth sees a sustainable up-tick assumes utmost importance. The increasing role of automation and other margin levers are critical, in our view.