Time To Stocks Pick IT

The Indian Information Technology (IT) segment has always remained a vibrant place. The reason is quite simple – it is a place where dynamics of the sector change frequently not only on the domestic front but also on the global canvas. Those who are able to anticipate it promptly and adapt to such scenario faster always emerge as a winner. There are many large Indian IT service companies that have proved their ability to do so in the past and have created wealth for the shareholders. However, of late, it seems that the gap between the largest IT exporter and the other companies has actually widened significantly. To put this in a perspective, here is an example. TCS, which is the largest Indian exporter in IT segment became the first company to cross the market capitalization of Rs 5 lakh crore. The noticeable factor is that while TCS joined the esteemed league, the gap between the fi rst and second player widened. To quantify, while TCS market cap stood at Rs 5.10 lakh crore, Infosys, the next large player, enjoyed a market cap of Rs 1.90 lakh crore. More importantly, if we consider the market cap of TCS, it is even more than the combined market cap of the next four companies, viz. Infosys, Wipro, HCL Technologies and Tech Mahindra. This despite the fact that the market cap of HCL Technologies and Tech Mahindra almost doubled in last one year. However, other players such as Infosys and Wipro have not managed to generate such returns.

We wish to bring to the notice of our readers the fact that while the likes of TCS, HCL Technologies and Tech Mahindra managed to anticipate the changing trends, biggies such as Wipro and Infosys failed to do so. Does that indicate a new scenario in the IT segment where the large companies have stagnated and the mid-tier companies have been able to grab the opportunities at a rapid pace? Does that mean the mid-sized companies are grabbing market share from large companies? If so, will it be the right strategy to look for a next TCS kind of a company amongst the mid-cap IT companies? Going ahead in the story, we will try to analyze various macro and micro factors to fi nd comprehensive answers to these questions.

ROBUST MACRO IMPROVEMENT IN TRADITIONAL MARKETS

 The IT spending is continuing to show improvement with US expecting to spend more on the new projects. Interestingly, the Indian IT service companies continue to show decent gains in share. On the global front too, the worldwide IT spending is expected to increase by more than two per cent on yearly basis. This growth in IT spending is healthy for Indian IT companies compared to the fl at spending in 2013. Further, this enables Indian IT service companies to expand much faster than the overall market as these companies continue to gain market share in the worldwide IT spending market.

In the recent quarter, deals flow has seen good traction continuing in the trend for the last few quarters. The strong momentum in IT outsourcing was seen broadly across all three major geographies, viz. the Americas, EMEA and APAC, predominantly led by higher new project activity over few quarters. The strength in IT spending was majorly driven by the manufacturing vertical, especially from industries such as consumer goods, capital goods and food & beverages. In the recent quarter – 2QCY14, Information Services Group’s (ISG) measurement of the deal market registered one of the strongest ever quarters measured by ACV (annual contract value) at USD 6.4 billion despite being a seasonally weak quarter of the year, making H1CY14 ACV of USD 12.4 billion the strongest since CY10.

 The data from the US economy over the past couple of quarters suggest that the US economy is expected to reaccelerate, despite weak fi rst quarter GDP growth. The data points such as US ISM, non-farm payrolls and unemployment rate showed positive signals for the US economy. Large deals were absent from the Americas geography but the mid to small sized deals showed some healthy momentum, largely from manufacturing and fi nancial services verticals across Americas. The IT outsourcing in EMEA region has increased remarkably over the last few quarters. Interestingly, Indian IT service companies have been gaining market share across these markets with the Nordics and Germany, Austria and Switzerland. There has been a good and robust deals activity from France, recording the best fi rst-half year in its history with healthy performance. Year-to-date EMEA order books now account for 51 per cent of the overall deal activity. The deal activity from Asia Pacific

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region too showed some traction during past couple of quarters. Notably, global peers Accenture and Cognizant tend to get the early share of a discretionary spending revival. Accenture too showed strong revenue growth in recent quarters, exhibiting a robust demand environment sustaining over the period. Accenture further suggests that it will likely achieve order booking close to the higher end of its previous guidance range of USD 33-36 billion in FY14. Cognizant management reiterated its revenue growth guidance for CY14 at 16.5 per cent on yearly basis. The global peer SAP also exhibited good results and strong growThin various business segments.

US IMMIGRATION BILL – NOT A BIG HURDLE

 The proposed Immigrations Bill in the US appears to have more negative implications not only in terms of costs, but also with regards to revenues. Further, this bill might require changes in the business model of IT service industry to handle new regulations posed by the Immigration Bill. Along wiThincreasing salaries for H1B employees as well as increased charges for H1B visas up to USD 10,000 fees for every additional worker on visa over the 50 per cent limit, the proposed bill will necessitate increased local hiring by IT service companies.

There are limited good things such as increase in the base case for the total number of H1B visas to 110,000 as against 65,000 currently and increase in the limit for additional visas to 25,000 as against 20,000 currently. The new norm like placement of non-immigrant visa-holders on client locations will have a revenue impact. This norm prevents H1B visa-holders to be placed at client locations. The IT companies will need to replace these workers with local workers or build-up local delivery centres. To implement this, the IT companies will require both time and investments. Further, the proposed bill intends to increase the minimum wages to be paid to H1B or L1 visa-holder employees as the minimum wages for these employees currently is meaningfully lower than prevailing wages locally. Further, IT service companies normally used to work at considerable higher onsite utilization with very thin benches onsite. The increased local resources will definitely limit the utilisation of employees. Further, the IT service companies will start increasing the use of sub-contractors which will also show considerable increase in costs. Further, increasing local resources and increasing minimum wages for H1B or L1 visa-holder employees will put considerable cost pressures on these IT service companies. However, this will have minimal impact on the Indian IT service companies, as the average salaries have moved up over the past two years. Hence, some incremental impact of stricter immigration rules is already captured in their financials. Further, in order to tackle these new regulations under the proposed bill, the IT service companies need to develop local delivery centres in the US. Further, these companies need to push higher quantum of business, thereby taking benefi ts of economies of scales and target the low margin US public IT spending opportunity. And finally, the new reforms have not been implemented presently and no fixed time frame has been decided for the implementation of the stricter norms.

CURRENCY FLUCTUATIONS

 The IT services industry being an export oriented industry remains leveraged on currency, especially the USD, with major billing for these companies being done in the currency. Hence, any depreciation in the rupee will result in margin expansion, as most of the expenses are in the rupee. For the past three years, there has been 40 per cent currency depreciation which has considerable benefited the margins of these companies. However, for the past couple of quarters, the rupee has shown some strength against the world’s major currencies. This event has been reflected in some correction in the Indian-listed IT service companies’ share prices. However, the currency appreciation is the natural phenomenon as the economy improves. Hence, the Indian IT service industry has to overcome the currency appreciation by higher revenue growth, increasing utilization and improvement in internal efficiency of delivery leading to a margin expansion. On the contrary, the rupee appreciation, a key reason for margin erosion, is too simplistic. There is a strong correlation between revenue growth and the ability to deliver on margin due to improved ability to control parameters such as utilization, onsite-off shore mix, etc. because of revenue growth.

SMAC AND NEW GEOGRAPHIES – NEXT DRIVERS FOR THE GROWTH

Social, mobile, analytics and cloud (SMAC) have become a game changer. The emergence of SMAC provided the way for IT service companies to become innovative, offering new ways to offer value to their clients. With the emergence of these new technologies, organizations are looking at integrating applications across enterprises seamlessly, with the ability to allow for easy.

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anywhere-anytime accessibility. SMAC is throwing up huge opportunities as firms want to optimize investments in current technology and drive growth by using digital technologies and platforms. The digital forces of SMAC will reach mainstream status in 2014 and create requirements, drive new purchasing and establish new competitive realities.

 According to the Indian Brand Equity Foundation (IBEF), Indian IT service companies are expected to generate USD 225 bn from SMAC-related revenue by 2020 of the USD 1 trillion global opportunity. Cloud represents the largest opportunity under SMAC, increasing at a CAGR of about 30 per cent to USD 650-700 billion by 2020, followed by social media, which will off er a USD 250 billion market opportunity by 2020. There are several large contracts due for renewal in 2014. Further, adoption of SMAC technologies is expected to show good growth momentum to Indian IT service industry. According to NASSCOM’s strategic review 2014 report, the Indian IT service industry’s exports is expected to grow by about 13 per cent in FY2014, predominantly driven by its ability to offer solutions with analytics and cloud-based services, along with traditional solutions. Traditional solutions account for a major portion of the revenue of Indian IT firms. However, with increased automation and platform-based services, SMAC will allow the IT service industry to offer more value to clients. The industry expects that Global 2000 firms will spend 15-16 per cent of their IT spending and outsourcing budgets on SMAC.

Indian IT services as well as product companies invested significantly in developing centres of excellence to showcase capabilities, building skill sets and marketing initiatives to ride the next wave of growth. The leading IT service companies such as Cognizant, Wipro, HCL Technologies, Infosys and TCS has considerably invested in SMAC computing technology services. Industry experts believe the focus on SMAC services will help these companies to expand their non-core business. Mid-cap firms are not left behind. Tech Mahindra, Persistent Systems and Zensar Technologies too have started preparing for SMAC solutions in a serious manner. During the times, the growth of Indian IT service companies is slowing due to its nature of highly export-driven industry and partly due to the large base effect, the large IT services companies have taken acquisition route to grow, bridge the gaps in their offerings, and make a quick entry into new geographies and new business verticals. The last few acquisitions done by the Indian IT service companies showed that these companies are primarily targeting entry into the Europe region. The Indian IT service industry wants to capitalize the current outsourcing opportunities in European environment to acquire good pie of the business and competence in the near future.

Additionally, these companies have acquired employees with a specific skill set or strengthen their capability in a particular sector. The IT service companies are also targeting to acquire new geographies to offer traditional services and want to capture the fastest growing emerging markets such as Brazil. These companies believe that the BRICS countries have a major role to play and achieve a leadership position in the global economy in the near future. The acquiring company in different geographies can diversify the company’s risk and the IT services companies will have an added source of revenue and will reduce their dependency on the traditional markets such as Americas and EMAE. These acquisitions also increase market share for the companies.

MID-SIZED COMPANIES TO OUTPERFORM BROADER IT SPACE

Considering good momentum over IT spending across the globe, the large IT service companies definitely show. performance. However, the performance will be with their traditional growth rates due to margin pressure and moderation in their revenue growth due to large-scale effect. Hence, we believe that the mid cap IT service companies which are offering good and attractive investment proposal will outperform the broader IT service industry. As the global IT scenario is changing we feel the mid-cap IT service companies are more quicker in adopting the changing environment compared to larger counterparts. Further, importantly these companies offer niche and specialized services to their clients. Because of focus on few verticals, these companies have gained significant capabilities across these verticals which build loyalty among their clients. Further, these companies have ability to serve clients of any size as large companies target bigger orders. Moreover, these companies score more in attrition levels over the bigger ones. As far as the pricing power is concern, the large companies generate revenues from few bigger clients and hence have lesser pricing power. The mid-cap IT service companies serve number of small clients and hence they are much less vulnerable to losing contracts from the clients.

We expect some of the mid-sized IT service companies to give better return on investment and a decent growth in their revenue and net profit. Further, because of above mentioned operational advantages, these companies look worthy of parking your money over the next one year. Here are the selected gems from the IT service industry which are expected to glitter more.

PERSISTENT SYSTEMS

Persistent management is well known for its ability to identify and invest in new technologies well ahead of its peers. Similarly, the company has significantly invested in SMAC, which is the next driver for the IT service industry. The company has built strong partnerships with the key platform vendors to develop their respective platforms and implement the same. The key platform vendors such as Salesforce.com, Amazon, Microsoft Azure, and HP’s Openstack have created a strong pipeline for cloud-related businesses for the company.

On inorganic growth front too, Persistent has been more proactive to expand and fill the gaps in its service portfolio or geographical markets. On the financial front, Persistent has shown strong margin track record with its margins being one of the highest among the mid-sized competitors. Its EBITDA margins which have ranged between 21 and 27 per cent in recent quarters are comparable to the large cap IT service companies. The current share price gives a PE multiple of 19.01 times its current earnings per share. Considering the company’s management capabilities and its strong financial track record, we expect the company to be ahead of its peers in taking benefit of strong IT spending across the globe.

GEOMETRIC

Geometric is engaged predominantly in developing technology soft ware product and providing technology solutions. The company operates in a niche segment and its services include product lifecycle management, global engineering and off shore soft ware development solutions. This differentiates Geometric from other mid-sized listed IT space and offers unique investment proposal to the investors.

The company has recently adopted new sales methodology to boost its deals pipeline. The company has changed its focus and started to bid for multi-million dollar and multi-year projects. Positively, this strategy has started showing results for the company. The company has experienced 57 per cent improvement in pipeline as compared to the same period last year. The first quarter of FY15 witnessed order book worth of USD 8.08 million against USD 5.51 million in the same quarter last year. The strong deal booking will definitely translate into improvement in its revenue over the near future. Further, on margin front too, the management expects some improvement because of increased efficiency. Interestingly, for the last couple of quarters, Geometric revenue from EMEA regions showed some traction and started reducing dependence on the Americas for revenues. At present market price, the share price is trading at a PE ratio of 18.20 times its current earnings per share. Considering its niche segment, increased deal bookings and expected improvement in profitability, one can surely look at Geometric as an investment opportunity.

HCL TECHNOLOGIES

HCL Technologies is a leading IT player among mid-cap IT service companies which showed consistent performance over the last couple of years. Surprisingly, the company’s key financials showed a better growth rate and was among the best in the industry, especially ahead of some of the large IT vendors such as TCS, Infosys and Wipro. This surprising performance by the company was predominantly because of growth in all its key verticals, healthy client additions and improvement in operational efficiency.

On the financial numbers front, HCL has showed a consistent sequential growth of more than three per cent in its quarterly USD revenue for straight eight quarters. The consistent growth was remarkable despite tough period for IT services industry for the last one year. HCL managed to sustain its EBITDA margins during the last eight quarters and, in fact, the company has managed to expand it to 26.70 per cent from 22 per cent during last five quarters. This margin expansion was a part of its continuing operational efficiency initiatives.

As the global IT spending is expected to increase, HCL will be in a better position to grab a major chunk of this opportunity, being a larger operational workforce as compared to other the mid-sized peers. The consistent financial performance and good amount of large deal booking prompts us to recommend this stock to our readers.