Stronger Market Share Gains For Indian Technology Firms In Digital Implementation Projects Remains The Key Opportunity

Mid-cap IT stocks have outperformed its large-cap peers in past one year. Amir Shaikh explains why the current momentum in IT stocks is expected to continue.

The Indian IT index has lagged the benchmark equity indices through the past calendar year, gaining nearly 11 per cent compared to a whopping 28 per cent rise in the Sensex during the same period. However, should the much-awaited revival in the IT sector materialise as expected, the sector may see some big gainers in 2018. 

When we looked at financial performance of India’s large-cap IT service providers, we found that aggregate revenue growth of these companies had slowed down. HCL Tech, Infosys, Tata Consultancy Services, and Wipro posted around 1.6 per cent combined sequential growth in the third quarter of the ongoing fiscal. This was partly attributed to slower market share gains from global players and partly due to a shift in the technology landscape resulting in slower deal conversions. Due to this dismal financial performance, most of the technology stocks underperformed the benchmark Sensex in calendar year 2017.

We believe a new tax regime in the US is likely to boost spending by the US firms on enterprise digital transformation. Further, the new tax bill that includes a base erosion and anti-abuse tax (BEAT) provision that impacts use of transfer pricing arrangements by certain Indian IT firms. But there is lack of clarity on the applicability of BEAT on Indian IT services firms. However, most firms are likely to restructure their client contracts into directly billed engagements to overcome any substantial increase in tax liabilities. Some of the companies such as TCS, and HCL Tech, which operate under the subsidiary structure in the US, come under the purview of BEAT. Hence, payment to Indian parent attracts higher tax rate. Other companies such as Infosys, Wipro, Mindtree, etc. are expected to witness a minor impact on their tax rate. 

Besides, if the bill ‘Protect and Grow American Jobs’ gets cleared in the senate, then it will have a major impact on Indian IT firms. Also, the rise in minimum wage of H1B visa holders to USD 90,000 would have an impact on companies' profitability. The expansion in constructing and integrating multiservice deals coupled with huge platform play and constant strong spending environment bodes well for the overall IT industry. Apart from this, the drop in legacy business and pressure in IMS due to adoption of public cloud is likely to be a threat in the coming years. 

Notably, stronger market share gains for Indian technology firms in digital implementation projects remains the key opportunity in coming years for companies which are invested in digital space. The past two years have been impacted by many external factors— Brexit, US election, increased noise around immigration and visas. The rationalisation of these effects will help the IT industry in better decision-making. Further, the northward movement of the interest rate in the US augurs well for the IT industry. 

NASSCOM has estimated around 7 to 8 per cent growth in IT exports in fiscal 2018 and 10 to 11 per cent growth in the domestic market. 

Mid-tier companies have outperformed tier-1 IT companies on revenue growth. This is led by improved delivery capabilities and maturity to structure complex contracts. Also, increasing share of digital and automation is helping mid-tiers IT companies to compete against larger players regardless of size. 

Looking at India’s largest IT service provider Tata Consultancy Service’s third quarter result of financial year 2018, we found that TCS reported strong sequential growth in the retail vertical and was confident of double-digit growth in the coming fiscal, i.e FY19. However, TCS’ BFSI vertical fell 1.5 per cent QoQ mainly on account of lower demand from large US banks which were currently spending internally on building collaborative and agile work places. The TCS management expects growth to pick up in mid-2018. On the other hand, Infosys seems to be more positive on BFSI and expects spends to come through on the new regulations, viz. Markets in Financial Instruments Directive, and innovative technologies. Further, the management expects discretionary spending to improve in BFSI vertical and indicated that with recent deal wins, it is well-poised to deliver better performance in 2018 as compared to 2017. Besides, insurance seems to be picking up as TCS announced few billion-dollar deals (Transamerica and Scottish Widows) in the last few months. Thus, we believe uptick in large deal wins by IT firms is expected to fuel growth in the coming fiscals. 

Infosys has lost the growth momentum it had gained during the previous years due to various issues like execution, leadership and weaker market conditions. However, with stabilisation of its senior personnel, Infosys is now well-poised for effective strategy implementation to achieve long term goal. 

The revenue growth has slowed down for the large-cap Indian IT services companies partly due to slower market share gains from the global players and partly due to a shift in the technology landscape, resulting in slower deal conversions. As a result, most of these stocks underperformed the Sensex over the last three years. While we see structural challenges for the Indian IT sector (due to the advent of automation and digital technologies that may require a more specialised/consultative approach), we see a possible cyclical turnaround for the stocks as IT spends start coming through. 

Reason for momentum in IT stock 

Looking at CY17, BSE IT index posted subdued performance in comparison with performance of the benchmark index Sensex. However, BSE IT outpaced Sensex by around one per cent in the first month of 2018. The stocks as a pack posted stellar performance. We are of the opinion that this exceptional performance was led by lower relative valuation of Indian IT stocks as compared to other industry. Further, in the recently concluded quarter, many major IT firms have initiated buyback offers to reward their shareholders. These buybacks also give an indication that IT firms are confident of their future growth. Further, the strengthening of the US dollar against the Indian rupee in the month of November 2017 boosted investors' sentiment. 

Going forward 

Increasing protectionism in the US resulting in higher onsite hiring, increasing sub-contractor costs and rising share of digital revenue are key concerns for the Indian IT firms, which might have adverse impact on their margins. However, Indian IT companies have been able to maintain their margins till now with the help of lower increase in headcount. Further,developments such as automation and right shoring are expected to act as cushion for IT firms for maintaining their margins in the coming quarters. The December quarter is a seasonally weak quarter for the IT industry due to holidays and furloughs in certain sectors like retail and manufacturing and lately in BFSI as well. Currently, the market for global enterprise software is at a growing stage and has huge potential for growth in the coming fiscals. A need for enterprise software is rising due to rising awareness, stiff competition and rising disposable income. It is used to meet the needs of an organisation, rather than individual users. Such organisations may consist of businesses, schools, interest-based user groups, clubs, charities, governments, etc. Further, limitless benefits of using enterprise software has attracted end-users in sectors such as banking, manufacturing, retail, communication, insurance, automobile, etc. Thus, we believe IT firms which cater to this segment would witness turnaround in the coming years. 

We believe lower valuations of Indian IT firms as compared to their long-term average bodes well for the investors to enter the IT sector. 

However, we remain cautious and selective on the sector and prefer cherry-picking. Further, Indian IT industry is expected to be the key beneficiary of improvement in global macroeconomic environment which would lead to increase in tech spending by global players. However, rupee appreciation and any delay in tech spending by global players might affect the growth of Indian IT service industry.

Mid-Cap IT Companies vs Large-Cap IT Companies 

During this challenging phase few mid-tier IT companies have delivered exceptional performance as they enjoy certain advantages like niche service capabilities, focused client servicing approach and ability to cater to clients of any size. Also, many mid cap IT companies are available at an attractive valuation relative to large cap IT companies. Compared to 1.6 per cent QoQ sales growth of large cap companies , mid-cap IT companies such as KPIT Technologies, Mindtree, NIIT Technologies and Polaris Consulting & Services have posted around 4 per cent QoQ sales growth in third quarter of ongoing fiscal. 

Below table clearly states that few mid-cap stocks who have delivered handsome return in calendar year 2017 compared to large-cap stocks 

Persistent Systems 

CMP : Rs782.70 BSE Code : 533179 Face Value : Rs10 BSE Volume : 24,087 

Persistent Systems is engaged in the business of building software products and providing complete product life cycle services. The company's segments include infrastructure and systems; telecom and wireless; life sciences and healthcare; and financial services. 

On the financial front, Persistent Systems posted a 4.35 per cent increase in its total income to Rs811.16 crore in the third quarter of FY2018 as compared to Rs777.33 crore in the same quarter of the previous fiscal. The growth in revenue was driven by intellectual property growth. The consolidated net profit of the company also improved 11.94 per cent to Rs91.67 crore in the third quarter of FY2018 as compared to Rs81.89 crore in the same quarter of FY2017. The company has reported EPS of Rs11.46 for the period ended December 31, 2017, as compared to Rs10.24 for the period ended December 31, 2016. The company’s margins have improved mainly due to increase in efficiencies and tax credit. 

On the valuation front, the company’s TTM PE stood at 20.9x, as against the industry PE of 19.66x, while its peers Oracle Financial Services and Polaris Consulting maintained TTM PEs of 31.78x and 36.86x, respectively. The company is virtually debt-free and has been maintaining a healthy dividend payout of 29.45 per cent. 

Persistent has transformed itself to address the larger enterprise digital opportunity. Product DNA, internet of things and partnerships with growing platforms are its key differentiators. The company is also looking for more acquisitions going ahead. The increasing share of high-growth businesses is expected to drive the overall growth and deliver strong earnings growth over the next two years. With growing demand from the digital space, Persistent looks well-placed to capitalise on the opportunities.

Cyient 

CMP : Rs638 BSE Code : 532175 Face Value : Rs5 BSE Volume : 41,095 

Cyient Ltd is engaged in providing engineering design, embedded software, information technology solutions and manufacturing support services. The company derives 34.7 per cent of its total revenue from the aerospace and defence vertical, while communications business contributes 23.3 per cent to the total revenues, followed by utilities and energy at 15.9 per cent and transportation at 11.2 per cent. 

The engineering players such as Cyient have been key beneficiaries of high speed internet connectivity and digitisation programmes globally such as Connect America Fund in the US and BharatNet in India. The company has historically focused on inorganic approach to drive growth. In September last year, Cyient acquired US-based B&F Design Inc for $5.5 million. 

On the financial front, Cyient Limited posted an increase of 14.46 per cent in its net sales to Rs377.50 crore in the third quarter of FY2018 on a yearly basis. The PBIDT of the company increased by 25.54 per cent to Rs104.70 crore in the third quarter of FY2018 as against Rs83.40 crore in the same quarter of the previous fiscal. The net profit of the company increased tremendously by 99.31 per cent to Rs143.90 crore in the third quarter of FY2018 as compared to Rs72.20 crore in the same quarter of FY2017. 

On the valuation front, the company’s TTM PE stood at 19.62x, as against the industry PE of 19.66x, while its peers Hexaware Tech and Tata Elxsi maintained a TTM PEs of 24.57x and 31.34x, respectively. The company is virtually debt-free and has been maintaining a healthy dividend payout of 28.05 per cent. Below table clearly states that few mid-cap stocks who have delivered handsome return in calendar year 2017 compared to large-cap stocks

The key project wins in aerospace and defence segment, high level of penetration in the transportation segment and high industry potential in communications and semi-conductor verticals will drive the company growth going forward. We recommend our reader-investors to BUY the stock