TECHNOLOGY - Ambitreports.ambitcapital.com/reports/Ambit_Technology_Thematic_Roll... · Infosys and Wipro see the ... (e.g. recent pre-results warning by Mindtree, project cancellation

TECHNOLOGY

September 2016

Research Analysts:

Roll with the punches

Sagar [email protected]: +91 22 3043 3291

Sudheer [email protected]: +91 22 3043 3203

TCS

TECHM

HCLT

INFY

WIPRO

Technology

September 09, 2016 Ambit Capital Pvt. Ltd. Page 2

CONTENTS

Roll with the punches ……………………………………………………………….3

Demand environment has deteriorated ………………………………………….4

Who wins in the downturn? ……………………………………………………….8

Long-term story remains attractive ……………………………………………..12

Remain BUYers despite EPS cuts ………………………………………………..18

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Roll with the punches

The demand environment has worsened since Brexit as reflected in commentary by both customers (Citigroup, Caterpillar, McDonalds) and IT services players and as per channel checks. Our “Rocky Balboa” framework – resilient portfolio, low-price-positioning and strong customer connect – shows TCS/TechM as best-placed and Infosys/Wipro as worst-placed. We cut FY18 EPS across our coverage by 6-12% due to reduced revenue growth as well as margins. But, we maintain our long-term thesis that revenue growth will accelerate for the large Indian IT services companies as they retain strong competitive advantages of low-cost-structure, knowledge of legacy systems, and CIO relationships. Current valuations (~3% USD dividend yield) are attractive in this context. TechM and TCS are our top BUYs and Wipro our top SELL.

Demand environment has deteriorated since the Brexit referendum Our primary checks say, “My clients are underspending budgets” and “deals are tough to close”. The near-term outlook appears even worse given commentary by several fortune 500 companies. A poorer revenue outlook typically implies cuts in IT budgets (Indian IT’s US revenue growth is 82% correlated with S&P500 revenue growth two quarters prior, adjusted for different vertical mix). Our “Rocky Balboa” framework of resilience ranks TCS best, Wipro worst In a poor macro backdrop, clients turn more price-sensitive and so prefer vendors with the positioning of “value for money” (e.g. TCS) vis-à-vis high innovation/ high quality (e.g. Infosys). Further, we prefer vendors with more resilient portfolios (by industry-segment, service-line mix, top-clients) and strong client-connects (less likely to lose out in vendor consolidation exercises). TechM (50% exposure to telecom, high exposure to managed services) is better placed than Wipro (worst account mining track record, highly project-based portfolio). Long-term story remains attractive Indian companies have been at a slight disadvantage to consulting-led companies, specialist digital shops and captives in the early stages of digital (e.g. building small apps). However, to derive the full value from their digital investments, customers will have to increase the size of digital engagements (to US$100mn+ transformation programmes from US$1mn proof-of-concept engagements) which Indian firms with low-cost structures and knowledge of both legacy and digital systems are best-placed to deliver. Further, the weak macro-economic environment is a transient worry. Use recent correction to BUY TechM, TCS, Infosys, HCLT but SELL Wipro Infosys and Wipro see the sharpest cuts (12%) to FY18 estimates whereas TCS, TechM, HCLT are less impacted (6-9% cuts). We do expect negative news flow (e.g. recent pre-results warning by Mindtree, project cancellation by Infosys) over at least the next couple of quarters. However, prices have over-corrected. TechM (leader in telecom) and TCS (best-in-class cost structure, excellent track record of investing ahead of demand) offer the most value at current prices.

THEMATIC IT SERVICES September 09, 2016

TechnologyPOSITIVE

Key Recommendations

Tech Mahindra BUY

Target Price: 580 Upside 26%

TCS BUY

Target Price: 2900 Upside: 25%

Infosys BUY


HCLT BUY


TechM appears to have the most resilient portfolio mix

By

verticals*

By service-

lines*

By client (rank)

Final rank

TCS 33% 62% 4 3

Infy 32% 41% 2 5

Wipro 39% 41% 5 4

HCLT 31% 73% 3 2

TechM 60% NA 1 1 Source: See Exhibit 7 on page 7 for full details

Research Analysts

Sagar Rastogi

+91 22 3043 3291 [email protected]

Sudheer Guntupalli +91 22 3043 3203 [email protected]

TCS and TechM are best-placed in our “Rocky Balboa” framework

Company P/E EPS CAGR

Implied FY18 P/E

Overall rank Portfolio Low-

price Customer

Connect TechM 12 9% 14 2 2 2 2

TCS 17 8% 20 1 1 1 1

Infosys 17 4% 18 4 4 4 4

HCLT 13 8% 14 3 3 3 3

Wipro 14 -1% 14 5 5 5 5

Note: P/E = one-year forward P/E, EPS CAGR over FY16-18; Source: Ambit Capital Research

mailto:[email protected]


Technology


Demand environment has deteriorated Even as global economic growth has been muted since the global financial crisis, the outlook has worsened in the past two months, partly due to potential Brexit. For instance, in its July update the IMF has reduced its estimate of US GDP growth in 2016E to 2.2% from 2.4% in the April update, vs. 2.4% in 2015. It has made a small change in UK’s GDP growth estimate for 2016 (1.7% from 1.9%) but a sharp change in the 2017 growth estimate (1.3% from 2.2%). US and UK together account for the majority of the revenues of Indian IT services companies. The bearishness is visible in the earnings calls of Indian IT’s largest customers. For instance, banks such as Citi and HSBC report pressure due to falling net interest margins (a key measure of profitability) and Brexit-induced uncertainty. Consumer-facing businesses such as Starbucks and McDonalds have talked about weakening consumer confidence impacting their revenue. Industrial customers such as Caterpillar have further downgraded their own revenue guidance. Our primary data sources on the frontlines chasing deals also tell us that the demand environment has worsened with comments such as “my clients are underspending budgets” and “deals are tough to close”.

Customers’ IT spend correlated with revenues As one would expect and as confirmed by our channel checks, most large enterprises (top 500-600 companies in US/Europe) calibrate their IT spend (including IT services spend) based on growth of their businesses. We were also able to confirm this through studying the correlation over the past 48 quarters. We studied correlations of Indian IT’s revenue growth with customers’ revenues and profits and found the highest correlation with revenue growth with a lag of two quarters. We considered evaluating correlation with capex and cash flow but abandoned the idea because of high volatility and low reporting frequency.

As shown in Exhibit 1 below, the correlation is significant in both US (82%) and Europe (65%). Europe is lower than the US possibly because of currency-related volatility. We use USD-growth for our correlation calculations and the revenue-split of Indian vendors by currency (e.g. EUR, GBP, NOK, SEK; not disclosed by Indian vendors) is likely quite different from the revenue-split of the STOXX Europe 600 by currency.

Exhibit 1: Indian IT revenue growth is correlated to revenue growth of S&P500 and Euro STOXX companies

Driving variable Output variable Driving variable lag

0 quarter 1 quarter 2 quarter 3 quarter 4 quarter

S&P 500 revenue growth ITS North America revenue growth (%, YoY) 56.5% 74.8% 81.5% 75.6% 60.3%

S&P 500 PAT growth ITS North America revenue growth (%, YoY) -17.3% -14.9% -11.4% -2.3% 10.1%

STOXX Europe 600 rev. growth ITS Europe revenue growth (%, YoY) 66.2% 64.9% 26.4%

STOXX Europe 600 PAT growth ITS Europe revenue growth (%, YoY) 13.5% 38.9% 45.3%

Note: Growth calculated using quarterly or half-yearly USD, YoY numbers. ITS = Indian IT services. We conducted this analysis over the last 12 years using the quarterly revenues of top-5 Indian IT services companies as a proxy for Indian IT services industry. We re-weighted the S&P500 based on the vertical-wise revenue split of the Indian companies.

Source: Bloomberg, Ambit Capital Research.

BFSI – worst hit segment While overall bank profitability in advanced economies (measured by return on assets) has recovered from the worst of the Global Crisis it remains low. The banks have been hurt by anaemic growth in loan-book and fee income as well as poorer profitability. The pressure is exacerbated by continued weak economic growth and low rates (see quote from a research paper below). This point also comes through in our conversations with the channel and comments made by key US and European banks in their latest earnings calls.

Even as global economic growth has remained muted since the global financial crisis, the outlook has worsened in the past two months, partly due to potential Brexit.

The correlation is significant in both US (82%) and Europe (65%).

Banks have been hurt by anaemic growth in loan-book and fee income as well as poorer profitability.

Technology


“Many advanced-economy banks are facing profitability challenges related to low net interest margins (NIMs) – typically measured as net interest income divided by interest earning assets – as well as weak loan and non-interest income growth. And while NIMs across many advanced-economy banks have been trending down on a longer-term basis, they have fallen more sharply since the Crisis – in part, as appears so, due to lower interest rates.”

- Extract from “Low interest rates and banks' net interest margins”, paper dated 18th May 2016, by Stijn Claessens (senior adviser in the Division of

International Finance, Federal Reserve Board; CEPR Research Fellow) et al.

“The environment remains challenging… Such geopolitical and economic uncertainty doesn’t create a clear picture for potential interest rate increases”.

- Michael Corbat, CEO, Citigroup on its earnings call, 15th July 2016

“I think it's too early to give you a revised guidance. But, we recognize that reaching these targets by 2019 is now uncertain and is likely to be more challenging.”

“100 basis point negative shift in rates without any management actions to protect asset side margins would reduce income by over £1.2 billion (over lifetime)”.

- Ewen Stevenson, CFO, RBS on its earnings call, 5th August 2016

Given continued weakness in economic growth and increased uncertainty in anticipation of Brexit, central banks cut interest rates or postponed rate hikes. This has resulted in falling bond yields. In this scenario, the interest rates that banks charge their customers fall at a far more rapid pace than the interest that they pay their depositors, leading to compression in net interest margins. For instance, Citigroup, one of the largest customers for many Indian IT companies, reported a net interest margin of 2.82% in the June 2016 quarter vs 2.91% in the June 2015 quarter and a high of 3.24% in the December 2008 quarter. This resulted in return on equity of just 7% in the June quarter, well below its theoretical cost of capital of 10%. In these circumstances, as expected, banks are postponing discretionary spend and/or asking for price-cuts on run-the-business spend.

“We started out with a business (Corporate and Institutional Bank) that had a front to back ratio of about 1:4.5. We've got a plan to deliver a cost structure which is 1:2 front office to back office.”

- Ewen Stevenson, CFO, RBS on its earnings call, 5th August 2016

“Discretionary spending in the banking sector remained soft, weighed down by macroeconomic concerns and a prolonged low interest rate environment. While we did see a return to healthy sequential growth in the second quarter, we expect banking discretionary spending during the second half of 2016 to be slower than we anticipated three months ago. Complicating the situation, of course, is the uncertainty arising from the Brexit vote in the UK. Economic growth forecasts and short-term to medium-term interest rate projections have generally been revised down since the vote. Given this new development, we see the banking sector being more cautious in spending over the near-term”

- Gordon Coburn, COO, Cognizant on its earnings call, 5th August 2016

“It is getting harder and harder to win business from BFSI customers. Hard for them to justify spending on a new technology project when there is a ban on hiring and travel.”

- IT services salesperson focused on BFSI

In these circumstances, as expected, banks are postponing discretionary spend and/or asking for price-cuts on run-the-business spend.

http://goo.gl/0moekI

Technology


Exhibit 2: US bank NIMs have been shrinking for some time now

Note: Data relates to average of top 5 US banks by asset size, i.e. JPM, Bank of America, Wells Fargo, Citibank and US Bancorp. Source: Bloomberg.

Exhibit 3: European bank NIMs have started shrinking recently

Note: Data relates to average of the largest 5 European banks by asset size for which data was available, i.e. HSBC Holdings, Barclays Plc, Deutsche Bank, Lloyds and RBS. Source: Bloomberg.

US consumer confidence has weakened… Even consumer-facing firms such as McDonalds and Starbucks which should not be impacted by the uncertainty around Brexit or US elections are complaining about weakness in US consumer confidence.

“What we did not and could not have fully anticipated was the profound weakening in consumer confidence in [Q2] that has caused sharp declines in QSR and restaurant traffic overall and has many of our competitors struggling with negative transaction comps…Starbucks is not immune to macro challenges that impact our competitors and retail overall.”

- Howard Schulz, CEO, Starbucks on its earnings call, 21st July 2016

“Clearly, it’s been fairly well documented on the consumer slowdown across most consumer segments…We’re not immune from what’s happening in the outside world…I think generally, there’s just a broader level of uncertainty in consumers’ minds…people are slightly mindful of an unsettled world. And when people are uncertain, when families are uncertain, caution starts to prevail and they start to hold back on spend.”

- Stephen Easterbrook, CEO, McDonalds on its earnings call, 26th July 2016

“My clients in the US are underspending budgets. They are even postponing digital spend. This is across segments. I hope it’s only because of uncertainty around US election, but I am not sure.”

- Senior management, mid-sized IT services company focused on serving B2C firms

…and so has demand for B2B customers “When we were sitting here a quarter ago, we were expecting sales in a range of $40 billion to $42 billion…We’ve taken that down…And the gist of that is just everything that we’re seeing in the economy today around the world…It’s not any one thing, I would say…we have sluggish economic growth throughout the world in general, but not enough to drive growth in our end markets. And the news we’ve seen over the last few months is definitely not giving us more confidence.”

- Michael DeWalt, VP, Caterpillar

“Clients remain cautious. There’s less sense of urgency…the U.S. economy is slugging along in the 1% to 2% GDP path that it has for some time, but as clients have gotten more cautious, our growth rates have slowed.”

- Robert Half, CFO, Keith Waddell

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6

McDonalds and Starbucks are complaining about weakness in US consumer confidence.

B2B customers such as Caterpillar are complaining about weak global capex spends.

Technology


Telecom and media segments most insulated Not surprisingly, telecom and media companies are most insulated from the impact of potential Brexit. For instance, in its last earnings call, BT’s management said that the group’s consumer segment’s services were “very, very important to the way people go about their daily lives or run their business” and were not discretionary. In its last earnings call, Amdocs, which derives 34% of revenues from AT&T, said that it continued to see “a stronger pace of discretionary spending in AT&T”.

Further, telecom and media firms have more compulsion to invest in IT services both because technology is a key competitive advantage in this segment and consumer behaviour is changing rapidly (e.g. use of Viber, Skype or Whatsapp instead of voice calls and SMSes; video viewing over smartphones instead of TVs).

Telecom and media companies are doing the following to retain revenues: (a) upgrading underlying technology (e.g. moving from 3G to 4G to 5G, or from HD to FullHD); (b) reducing costs by moving to software-defined networks (SDN) or Network-Function-Virtualisation (NFV); (c) offering a bundle of services such as cable and broadband (e.g. AT&T is now offering streaming content for the mobile with the help of its acquisition of DirecTV); and (d) using digital technologies such as advanced analytics to get closer to the customer. Each of these requires additional investments in technology and thereby creates opportunities for Indian IT services vendors.

“While we didn’t support Brexit on a corporate level or do we respect the voters’ decision…we’re not actually that worried at all about the future here. We’ve seen no slowdown in our sales levels in UK.”

- Mike Fries, CEO, Liberty Global

Consumer-demand for their services is steady and technology is a key competitive advantage in these segments.

Technology


Who wins in the downturn? “It ain’t about how hard you hit. It’s about how hard you can get hit and keep moving forward. It’s how much you can take. And keep moving forward. That’s how winning is done.”

- Rocky Balboa

Vendors that have a resilient portfolio mix (with respect to industry segment, service-line, clients), a low-price-positioning and better customer connects are likely to see a lower dip in revenue growth and margin than others.

Exhibit 4: TCS and TechM appear best placed on our “Rocky Balbo” framework whereas Wipro is last

TCS Infosys Wipro HCLT TechM Comment

Overall rank 1 4 5 3 2 Portfolio mix 3 5 4 2 1 TechM ranks best due to high exposure to telecom, Infosys suffers due to higher

exposure to project-based work Low price positioning 1 5 4 2 3 TCS ranks best, Infosys sells relatively more on an innovation-led positioning

Customer connect 1 2 5 4 3 Wipro ranks the least because until recently, it forced regular rotation of its relationship managers

Source: Company, Ambit Capital Research.

Resilient portfolio mix

Some segments are more resilient than others in the current environment. For instance, among verticals, the telecom and media industry segment appears to be least impacted whereas BFSI and travel segments are most impacted. Within service-lines, infrastructure management services (IMS), business process outsourcing (BPO), application maintenance and enterprise software maintenance are less exposed to discretionary spend as opposed to application development, enterprise software implementation work, etc.

We sanity-checked our categorisation of service-lines and verticals into resilient and non-resilient segments (to the transient macro-economic weakness) by looking at relative performance during the GFC (Jun-08 to Jun-09 was the weakest period for Indian IT services revenues).

Exhibit 5: IMS, BPO, ADM and Testing were the most resilient service-lines during the GFC

Note: ADM = Application development and maintenance, which is mostly application maintenance. Ent. S = Enterprise application services. Engg. = Engineering services. Source: Company data, Ambit Capital

Exhibit 6: Retail, Media and Healthcare were the most resilient verticals during the GFC

Source: Company data, Ambit Capital

However, there can still be differences between sub-segments and specific customers. For instance, within BFSI retail banking is less vulnerable than capital markets and within capital markets Citigroup is possibly better positioned than Deutsche Bank or RBS (based on our limited understanding of the earnings call commentary and recent share price movements). Similarly, there can be differences between companies in the same service-line as well. For instance, we know that a much higher proportion of TCS’s IMS work is non-discretionary spend compared to Wipro.

17%

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ing

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Rev. growth (YoY, USD, organic)38%

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Vendors that have a resilient portfolio mix (with respect to industry segment, service-line, clients), a low-price-positioning and better customer connects are likely to see a lower dip in revenue growth and margin than others.

We analyse portfolios by exposure to industry-segments, service-lines, discretionary spend of customers and also top customers. TechM appears best-positioned.

Technology


Exhibit 7: TechM appears to have the most resilient portfolio mix

Resilient verticals as %

of revenue

Resilient service-lines as

% of revenue

Top-clients resilience

(rank) Final rank

TCS 33% 62% 4 3

Infosys 32% 41% 2 5

Wipro 39% 41% 5 4

HCLT 31% 73% 3 2

TechM 60% NA 1 1

Note: For estimating the resilience of top-clients we made a subjective assessment of resilience based on our reading of the latest earnings call and recent share price performance (for each of the top-10 clients of each vendor), weighted by our assessment of individual contribution to overall revenue.


“Wipro’s IMS is highly project-based. For instance, for a recent multi-million dollar project in Saudi Arabia, Wipro bought the hardware, software and established all the infrastructure on a turn-key basis but will get zero downstream revenue from it. Dave Chopra, who has been hired from TCS, is fixing some of these issues.”

- Senior industry analyst at a large outsourcing advisory firm

“TCS’s IMS is likely to be a lot more fixed price, steady annuity business whereas Wipro is more of a hardware/software supplier. HCLT also has some proportion of discretionary, transformational work in its IMS segment, partly because they work on larger engagements. Infosys and Cognizant typically have FTE-based-pricing on many of their IMS projects as well, so this can be ramped down if the client wants.”

- Senior employee of an IT services company

“We have more than normal share of discretionary spend in a large number of our customers and net growth for us is a function of both the projects getting over and the new projects that we win and ramp up.”

- Abid Ali Neemuchwala, CEO, Wipro (Jun-16 earnings call)

Low-price positioning

In a tough economic environment, customers turn more price-sensitive and are more likely to prefer the vendor with lower prices over one with an innovation-driven and/or consulting-led strategy. Also, customers often consolidate their IT vendors (say from five to three), thereby shifting volumes to vendors that are able to offer the best prices in return for higher volumes.

Clearly, vendors with the best cost structure, i.e. processes to execute projects with high proportion of junior employees, utilisation and offshore-based employees without impacting customer satisfaction, are best placed. Increasingly, code reuse and proprietary tools are also important to improve employee productivity and thereby achieve lower costs.

Positioning is also a function of strategic choice. For instance, TCS, Infosys and Wipro have a higher proportion of campus recruits in their overall hires (“build” HR strategy) compared to HCLT or TechM (“buy” strategy) who relied more on lateral hires poached from the former companies. Companies with “build” strategy enjoy the benefit of lower per-capita salaries than companies with a “buy” strategy, which more than compensates for additional investments required in training. Further, between TCS and Infosys, we understand that TCS’s positioning offers best value for money whereas Infosys markets itself as a premium partner.

In a tough economic environment, customers turn more price-sensitive and are more likely to prefer the vendor with lower prices over a vendor with an innovation-driven and/or consulting-led strategy.

Technology


Unfortunately, it is impossible to draw comparisons between companies on the basis of ratios of reported financial and operating metrics such as cost per employee because of differences in revenue mix and wide variance in the salaries of employees across segments. For instance, a consultant might earn as much as 10x the salary of a BPO employee even if both are delivering services from the same office location. Also, some companies have stopped reporting key operational metrics such as utilisation, offshore-mix and employee pyramid.

So we have to rely on channel checks. Our channel checks report that in terms of cost-structure, TCS (best-placed) > Wipro > Infosys > TechM > HCLT (worst-placed).

“You have to understand that TechM was a US$300mn (revenue) company not very long ago. Their processes related to employee staffing, productivity are quite immature. However, they try to compensate for this by squeezing hard on salaries. See they give wage hikes effective 1st January when the rest of the industry gives wage hikes effective 1st April of the previous year. In the last cycle, I heard that they gave zero wage-hikes to many people.”

- Former employee of TechM

“TCS gets its cost-ethos from GE which forced its vendors to offer better prices year after year. Unlike Infosys or Wipro who consciously reduced their dependence on GE, possibly because they were lot more focused on margins then, TCS didn’t. GE was possibly its largest client when it listed.”

- Former employee of TCS

“TCS has an incredible ethos of focus on costs. Even their internal employee entertainment programme budget would be engineered down – for instance, instead of getting a performer from outside, they would ask TCS employees to play the guitar! They are open to their employees about the fact that they are not the best-paymasters, but they play up other aspects like training, exposure, etc. and they also hire people who are not that money-oriented.”

- A consultant who worked with TCS more than a year ago

“HCLT’s cost structure is not that strong because the focus has always been on growth, not on margin. Despite its high margin focus, Infosys always was a good paymaster relative to other Indian companies and with Vishal Sikka coming in, it has widened the gap. Which Indian IT company gives iPhones to its employees!”

- Senior employee of a leading global IT services firm

Strong customer connects

When customers consolidate their IT spend, the vendors who get a larger share not only offer the best price, but also have the strongest relationship. By strength of relationship, we mean: 1) level at which interaction occurs (e.g. does the CEO of the customer regularly talk to the CEO of the vendor), 2) level of comfort and trust built with the relationship manager, 3) track record of execution in the past and 4) the number of departments/service-lines that are being catered to (clients first eliminate the small vendors that do not offer any differentiated service).

Average size of a top-10 customer is a good proxy to this and so our ranking is TCS (best) > Infosys (US$220mn) > TechM (US$165mn) > HCLT (US$147mn) > Wipro (US$136mn, worst). Note that TCS does not report the proportion of revenues from its top-10 clients.

For instance, we understand from channel checks that about three years ago, Infosys lost a significant piece of business from BT almost overnight, because after Nandan left, there was not a single person in the company who could call up the CEO of BT and make a strong case for Infosys. Vishal Sikka hopefully brings in strong CEO-connects.

When customers consolidate their IT spend, the vendors who get a larger share not only offer the best price, but also have the strongest relationship.

Technology


“An Indian vendor will need to offer a seriously large price-discount to an Accenture customer to wrest away its share. That’s because the Accenture client-partner and the customers CIO have been playing golf together for years. On the other hand, you have Wipro which keeps rotating its client-partners every eighteen months.” (We understand that Wipro has stopped this practice recently).

- Accenture salesperson

“TechM has far higher customer concentration than any other Indian company and it realises the risks inherent there. So it ensures that it cross-sells far more services to the client than its rivals. Remember when the client reduces the number of vendors, it will first eliminate the small vendors that offer only 1-2 service-lines without much differentiation.”

- Former employee of TechM

Technology


Long-term story remains attractive Indian vendors are currently winning fewer digital projects as compared to peers with consulting expertise (e.g. Accenture), niche firms (Globant) and captives. However, this trend will reverse once the digital projects increase in size and their cost structure and knowledge of legacy systems becomes prized once more. Further, it would be wrong to think that Accenture’s revenue growth acceleration implies that Indian IT has stopped gaining share in global IT services spend. Apart from Accenture, none of the top-10 non-Indian IT services companies are growing faster than the top-6 Indian IT services companies. Finally, cloud and automation are unlikely to shrink global IT services spend. Contrary to the perception that Indian vendors have been caught on the wrong foot with new technologies, they have been investing in blockchain, IoT, etc. and their good track record of moving up the value-chain gives confidence.

Indian IT will regain competitive advantages in digital We are still in the early stages of digital adoption wherein projects are small and are being driven by business stakeholders rather than the CIO’s office. This blunts the key competitive advantage of Indian IT which comprises lower costs and strong relationships with the CIO’s office. Often, the business stakeholders are dependent on consultants, which puts MNCs such as Accenture in a far-more advantageous position. Specialised companies such as Globant and Mindtree are also at an advantage over larger Indian IT vendors in this situation.

However, once projects become larger, cost, knowledge of legacy IT systems and relationships with CIOs will once again become important criteria for vendor selection. As per our channel checks, it takes 12-18 months for a digital project to go from proof-of-concept or pilot stage to become full service engagements. However, given the weak macro-economic conditions, this period might get elongated.

“Yes, increasingly digital projects are being funded by the marketing budget and so smaller companies that attend the conferences that CMO’s go to are more successful than traditional IT services companies that attend the CIO conferences. However, eventually, big digital work will happen through the IT budget. Business heads are highly involved, but they won’t start doing the CIO’s job.”

- Senior salesperson of large Indian IT services company in June 2016

“The whole game has changed. Service-providers need to ideate along with the buyers. The buying audience has shifted in a major way from CIO’s office to the business stakeholders. Indian providers don’t have a strong consulting practice and they need to adapt their go-to-market approach. I do agree with you that eventually customers will need a lot of traditional work to extract full value from digital.”

- Senior industry analyst in August 2016

Rise of captives is temporary We see no change to the long-term trend of higher outsourcing of IT services because of the benefits of lower costs, higher agility and for access to best-practices and latest trends in technology. A few customers have recently chosen to in-source IT services spend either because they think it is too core to their business or because they are dissatisfied with their IT services vendors. However, we see no change to the long-term trend of higher outsourcing of IT services because of the benefits of lower costs, higher agility and for access to best-practices and latest trends in technology.

“We think that some customers had outsourced too much early on including work that is extremely core to their competitive advantage. We are now seeing some of them pull-back. But the long-term trend is definitely towards outsourcing.”

- Senior industry analyst in August 2016

Technology


“35% of outsourced people are not proficient but in-house people were proficient. The pyramid has gone out of shape with too many junior resources. I think about cost only when I’m buying a product, but I think of value when I think about services. Earlier, we were willing to play the cost arbitrage. Today, our captive centres in India (we have 47 across the world) can match the cost of the Indian providers and we don’t need to make margin, so we invest in talent. Robotic Process Automation is only a matter of time”

- Bob Rosetta, ex-sourcing officer, Citigroup in February 2016

“Bob needs us just as much as we need him. He needs to decide whether he wants to pay US$30/hour (to captive) or US$16/hour (to Indian vendor) and for many types of work, outsourcing makes the most sense. Also, outsourcing gives the benefit of having resources on tap with quick ramp-up or quick ramp-down. For all his talk, Citigroup remains the single largest customer for Indian IT.”

- Senior salesperson at an IT services company in February 2016

“Captives are a reality of our business. It is a cyclical thing, there are times when you see more captives coming in play and times when you see people exiting captive. So now this is a cycle where we are seeing more and more captives coming in.”

- Pravin Rao, COO, Infosys in June 2016

Indian IT is not losing market share to global IT Accenture’s recent growth spurt is not representative of all large MNC vendors. In fact, even in CY15, the top-10 non-Indian IT services vendors grew slower than the top-6 Indian IT services providers.

Exhibit 8: Top 6 Indian vendors are growing faster than the non-Indian MNCs even now…

Note: Adjusted for acquisitions of revenue> $500mn. CTSH: Cognizant; TechM: Tech Mahindra. Bloomberg; Source: Ambit Capital research, Company.

Exhibit 9: …so fears that they are losing market share is misplaced.

Note: IBM= Global Business services + Global Tech services segments. FJTSU: Fujitsu Ltd Technology Services segment. HPE: Enterprise Services segment. Xerox: Services segment. ORCL: Oracle Services segment. ACN: Accenture; CAPP: Capgemini; NTT: NTT Data; Adjusted for acquisitions of revenue> $500mn; For FJTSU & NTT, organic revenue growth in reported currency (JPY) is considered. Source: Ambit Capital research, Company, Bloomberg.

11%

17%

11%

6%

11%

3%

-10%

-5%

0%

5%

10%

15%

20%

TCS

CTS

H

Info

sys

Wip

ro

HC

L

Tech

M

Revenue growth (cc, YoY)

Aggregate: 12%

-2%

11%

1%

-6%

1%

8%

0%

-1%

-5% -4%-10%

-5%

0%

5%

10%

15%

20%

IBM

AC

N

FJTS

U

HPE

CA

PP

NTT

Ato

s

Xero

x

CSC

ORC

L

Revenue growth (cc, YoY)

Aggregate: 1%

Technology


No risk from changing technology IT services is not vulnerable to product cycles

IT services vendors are not vulnerable to product cycles unlike most other global technology sub-segments such as semiconductors, software, etc. This is because they are less technology firms and more suppliers of people that solve a wide variety of business problems using a wide variety of technologies. They are not dependent on one specific business problem or one specific technology unlike a software company or a hardware firm. Employees can be re-skilled or replaced in-line with changing requirements. The dynamism and complexity in both business and technology will ensure that there is a need for their services for a long time to come.

Good track record of moving up the value chain

Specifically, Indian vendors have a good track record of navigating prior technology cycles such as the move from mainframes to client-server to rise of packaged ERP software and then the internet. This gives confidence that they will be able to navigate emerging technology trends as well.

Indian vendors have been investing in building the right capabilities

Consensus is concerned that the large Indian IT services companies are ignoring automation, straight-through processing or Business Process as a Service, Internet of Things. However, this is not true. Each of the large Indian IT services companies have either built proprietary cognitive computing platforms (e.g. TCS’s Ignio, Infosys’ Mana), partnered with automation software providers (e.g. TechM-Blueprism, HCL-Blueprism) or acquired (Infosys-Panaya).

Further, these vendors have also built/acquired a number of platform solutions e.g. TCS’s procure-to-pay platform or Infosys-Skava. These companies are actively engaging with clients on the technologies of tomorrow such as blockchain, Internet of Things, Industry 4.0, etc.

Cloud and Automation will not shrink IT services spend The recent weakness in the revenue growth of leading Indian IT services companies as well as increasing adoption of cloud (e.g. AWS, Microsoft Azure) and automation software (e.g. Blueprism, Automation Anywhere) have led to speculation that the adoption of the cloud and automation is negative for spend on IT services.

We disagree for two reasons. One, enterprise customers have an insatiable appetite for technology given that it is increasingly the source of competitive advantage across industry segments. Two, the transition to cloud will lead to increased spend over the next 1-2 years and hence increased complexity in the technology ecosystem augurs well for IT services spend. We now delve into each of these new drivers of demand for IT services.

Enterprise customers will spend their savings and then some more

The adoption of cloud and automation might cannibalise revenue for an individual project. However, the customer is likely to use those savings to spend more on other projects especially as technology is increasingly becoming the source of competitive advantage for companies across industry segments. So at the customer level, IT services spend is highly unlikely to drop. This is supported by the fact that data or information is growing at an exponential pace. Cisco expects data generated by people and machines to increase 5x over 2014-19.

Further, new-age technologies such as cloud, mobile and analytics are expanding the addressable market for IT services. For instance, now IT services companies can pitch to the chief marketing officer of a consumer products company for a project to generate insights from social media chatter about the products.

Technology


The evolution of the Indian brokerage industry (specifically, equity research in the Indian markets) might provide a suitable analogy. Tools like Microsoft Excel, custom macros, and the Google search engine have sharply reduced the amount of time required to model scenarios, create charts and reports or gather information about the competitive landscape. However, the amount of time spent by an analyst researching the stock has remained the same or possibly even increased as the depth in research has increased.

This thesis – of work expanding even as technology makes it easier to get the job done – is validated not just by the official spokespeople of Indian IT services companies but also by buyers of IT services, cloud-implementation partners and friends who are employees at IT services companies, who can logically be expected to give an unbiased view (see the quotes given below).

IT services companies that have a full-suite of service offerings, good delivery quality and a low-cost structure will be able to capture the new projects even as they pass on productivity-savings to their customers in legacy projects.

“A bank’s competitive advantage used to be having branches near to customers but in the internet world who cares about that? User experience on a mobile phone, website or ATM is more important. And what drives that? Technology in the form of cutting-edge software products and services around that”.

- Employee of a leading financial software company

“I have never seen the IT budget of an enterprise customer going down. For instance, a large European auto company will derive 30-40% savings by offshoring their Infrastructure Management Services spend as well as implementing automation software. However, they want to use this money to track the location of all their vehicles. Not only would this allow them to platformise their product, i.e. offer services such as emergency services but also to optimise the supply chain of auto components for their service centres. You see, after every 5,000km, the fuel oil needs to be changed, after every 50,000km, the tyres need to be changed and so on”

- Senior employee of an Indian IT services company. Part of his role is to scout for new technology solutions to bring productivity savings to his

customers.

“We recently won a cloud-migration project from a large customer in the pharmaceutical industry segment. The client currently employs 100 people, costing US$100,000 p.a. on average to manage his infrastructure. After we migrate to the cloud, we will need just 15 people to do this. However, the migration process will take two years and during this time we will charge consulting fees at the rate of US$100/hour (to put this in perspective, the typical cost of an offshore resource for infrastructure management services would be less than US$20/hour). So the client’s spend per annum will remain at least at US$9mn p.a. Further, we are simultaneously working on an analytics projects with the customer – these would not have been possible without migration to the cloud of some applications. We have currently won a US$500,000 project that will last six months and we don’t have visibility for the future, but it is more likely than not that we will get another such project if not a bigger one. Then, we will also charge for cloud federation services, i.e. managing clouds from multiple providers as well as the company’s data-centre.”

- Senior employee, cloud implementation services company

It is worth noting that previous deflationary events in the IT services industry such as the adoption of packaged software applications (which cannibalised some custom application development work) as well as offshoring of IT services (which allowed customers to avail of the same services at one-third the cost) have not led to IT budgets shrinking.

Technology


Exhibit 10: Infosys’ ADM revenues continued to grow even as it reduced as a proportion of overall revenue

Source: Company, Ambit Capital

Exhibit 11: ERP implementation and maintenance became an additional revenue stream for Infosys

Source: Company, Ambit Capital

Exhibit 12: Global IT services spend has continued to grow despite rise of outsourcing, offshoring and productivity improvements

Source: IDC

Transition-work and higher complexity will boost IT services spend

IT services companies’ core value proposition is to solve business problems with the help of technology. Because business and technology are both ever-changing and complex, there will always be the need for people supplied by IT services companies.

With IoT, the definition of infra is changing from just computers to ATMs/factory machines as well. Rightscale’s cloud computing survey shows that customers use 6 clouds on average and that lack of resource/expertise is the #1 challenge in moving to cloud.

“The problem is that end users can’t get the cloud from a single provider, no matter how large. Even market giants like Amazon have limited geographic presence, with infrastructure only where it’s profitable for them to invest. As a result, outside the major countries and cities, coverage from today’s ‘global’ cloud providers is actually pretty thin. Iceland, Jordan, Latvia, Turkey, Malaysia? Good luck. Even in the U.S., you might find that the closest access point to your business isn’t even in the same state, let alone the same city.”

- Ditlev Briedahl, CEO of OnApp, a cloud management company

0%

20%

40%

60%

80%

-

500

1,000

1,500

2,000

2,500

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

US$ mn ADM Revenues for Infosys

ADM revenue (LHS) % of total revenues (RHS)

0%

10%

20%

30%

-

200

400

600

800

1,000

1,200

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

US$ mn ERP Revenues for Infosys

ERP revenue (LHS) % of total revenues (RHS)

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

-200

-100

0

100

200

300

400

500

600

700

FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

Global IT services spend (US$ bn) Growth (%, YoY)

Technology


“European companies, especially, hate monopolies. So they do not want cloud services from Amazon (Web Services), they’ll take it from Microsoft (Azure). Now if you’re a global company with some global applications running on Amazon’s cloud, European applications working on the Microsoft Azure cloud and your finance department’s application working on the IBM cloud, it’s going to be a very hard job to pull the data across multiple applications to make a common report. You need a cloud federation provider who will make a dashboard so that you feel that everything is on one cloud”

- Senior employee of an Indian IT services company. Part of his role is to scout for new technology solutions to bring productivity savings to his

customers.

“The enterprise certainly saves money if it buys a monthly subscription from Amazon Web Services instead of purchasing his own servers or if he buys Workday instead of Peoplesoft. But the savings are primarily on hardware and software and not necessarily on services. Someone needs to be there to troubleshoot (infrastructure management services) or to connect his legacy systems to the new system so that there is one true view of the customer. And one thing that I’ve learnt in my long career in IT is that data-integration projects never really end.”

- Former CIO-Asia Pacific region, global chemicals giant

We also see no risk to profitability So far, Indian IT vendors have enjoyed good profitability (20%+ EBIT margin for the top-5 Indian IT vendors) because of their low cost structure. Approximately 80% of delivery personnel are based in India and they are at least 50% cheaper than a US-based or UK-based IT engineer even adjusted for any differences in productivity. This economics is unlikely to change with the new technologies. Capabilities in new technologies might be hard to find in India initially, but the excellent training infrastructure of these companies will ensure that they acquire these capabilities quickly.

“There is a strong culture of learning in the Indian IT services industry. Employees get nervous if they have not added anything to their CV (curriculum vitae) in six months.”

- Senior delivery manager, a large Indian IT services company.

Technology


Remain BUYers despite EPS cuts We have cut our FY17-18 EPS estimates by 3-12% across our large-cap IT coverage due to both cuts in revenue growth and margin. We expect Indian IT’s customers to reduce IT spend in terms of volumes as well as pricing. The volume cuts will be higher in the more vulnerable industry segments such as BFSI and travel and in service-lines oriented towards discretionary spend such as application development and enterprise software implementation. Pricing pressure will be greatest for segment-vendor combinations where the vendor’s differentiation is least. Usually, but not always, scale is a good proxy for the extent of differentiation in a particular segment. For instance, Wipro/HCLT will likely see more pricing pressure in the BFSI segment as compared to TCS/Infosys. So, the EPS cuts are the highest for Infosys/Wipro (12% cut to FY18 EPS) which have less resilient portfolios as compared to TCS/TechM/HCLT (6-9% cuts to FY18 EPS). We see no near-term catalysts for the Indian IT services stocks and expect 6% earnings CAGR for top-5 Indian companies over FY16-18 as compared to 20% over FY11-16. However, we remain positive on the long-term opportunity for the sector (large digital projects, IoT) and given the recent price correction remain BUYers. At current valuations, our pecking order is TechM (top BUY), TCS (BUY), Infosys (BUY), HCLT (BUY) and Wipro (top SELL).

Exhibit 13: Summary changes to estimates

TP Revenue EBIT margin (bps) EBIT EPS

FY17 FY18 FY17 FY18 FY17 FY18 FY17 FY18

TCS -2% -2% -4% -50 bps -50 bps -4% -6% -4% -6%

Infosys -18% -2% -9% 00 bps -70 bps -3% -11% -3% -12%

Wipro -13% -3% -8% -80 bps -120 bps -8% -14% -7% -12%

HCLT -6% -1% -3% -40 bps -50 bps -3% -6% -3% -6%

TechM -11% -1% -2% 00 bps -110 bps -2% -10% -2% -9%


Valuations will improve once growth comes back The Indian IT sector’s P/E (one-year-forward, top-5 listed companies by market-cap) has de-rated over the past two years to 16x from 22x, as EPS growth has dived to 9% YoY (12m ended Jun-16) vs. 32% YoY (12m ended Jun-14). As discussed in the earlier sections, the slowdown is due to transient factors (Indian IT at a disadvantage in early stages of digital, poor macro-economic environment) which should eventually reverse.

Exhibit 14: Indian IT’s valuations have steadily declined over the past two years

Source: Ambit Capital research, Bloomberg, company. Note: Top 5 comprises TCS, Infosys, Wipro, HCLT & TechM

14

16

18

20

22

24

Sep-11 Sep-12 Sep-13 Sep-14 Sep-15 Sep-16

Aggregate one year fwd P/E of Top 5 Indian IT service providers

The EPS cuts are the highest for Infosys/Wipro (12% cut to FY18 EPS) which have less resilient portfolios as compared to TCS/TechM/HCLT (6-9% cuts to FY18 EPS).

The Indian IT sector’s P/E has de-rated over the past two years to 16x from 22x, as EPS growth has slowed to 9% vs. 32%.

Technology


Exhibit 15: …driven by slowing earnings growth…

Source: Ambit Capital research, Bloomberg, company. Note: Aggregate comprises TCS, Infosys, Wipro, HCLT & TechM

Exhibit 16: …even as RoE has largely remained intact

Source: Ambit Capital research, Bloomberg, company. Note: Aggregate comprises TCS, Infosys, Wipro, HCLT & TechM

Exhibit 17: Consensus has penalised IT sector with lower valuations compared to the Nifty due to lower growth, even though the return ratios are higher

CMP Price perf P/E EPS growth ROE

3m 6m FY17 FY18 FY17 FY18 FY17 FY18

TCS 2,322 -11 -1 18 16 5% 11% 33% 31%

Infosys 1,038 -15 -8 17 16 4% 4% 22% 22%

Wipro 474 -16 -13 14 13 -7% 6% 17% 16%

HCL T 774 4 -5 14 13 9% 6% 27% 25%

TechM 459 -13 4 13 11 2% 17% 20% 20%

Top 5 Indian IT 16 15 4% 8% 24% 23%

Nifty 8,953 8 20 19 16 16% 20% 14% 15%

Source: Ambit Capital research, Bloomberg, company

For perspective, consider the long-term estimates for TCS implied by the current price as shown in exhibit 18 below. For our reverse discounted cash-flow model, we use a hurdle cost of equity rate of 14% and a terminal growth rate of 5%.

Exhibit 18: Current price implies fairly modest growth estimates for TCS

FY06 -16A FY16 -26E Comment

Base assumptions:

Global IT services spend CAGR (USD) 3.1% 3.0% Given the increasing importance, heterogeneity and pace of change in technology, we believe that this is conservative.

Average EBIT margin 26.3% 26.2% High switching costs, cost-focused architecture/strong should ensure that margins remain high

Avg. change in working capital as %age of incremental revenue 6% 12%

Impacted by currency exchange movements. TCS has operated with a working capital cycle of 40-50 days of sales in the past (~12% of revenue) and we don't expect any change going forward.

Avg. capex as %age of revenue 4% 2% Lower growth will require lower capex.

Implied estimates:

Revenue CAGR (INR) 23.4% 9.6% This appears fairly conservative given that TCS is aggressively expanding into new markets (e.g. Japan, continental Europe), industry segments (e.g. healthcare) and service-lines (e.g. digital, IoT)

Terminal market share in global IT services spend 1.8% 3.3%


0%5%

10%15%20%25%30%35%40%

Jun-

11Se

p-1

1D

ec-1

1M

ar-1

2Ju

n-12

Sep-

12

Dec

-12

Mar

-13

Jun-

13Se

p-1

3D

ec-1

3M

ar-1

4Ju

n-14

Sep-

14

Dec

-14

Mar

-15

Jun-

15Se

p-1

5D

ec-1

5M

ar-1

6Ju

n-16

Net income growth (YoY, LTM, INR)

24%

28%

32%

36%

Aug

-11

Dec

-11

Apr

-12

Aug

-12

Dec

-12

Apr

-13

Aug

-13

Dec

-13

Apr

-14

Aug

-14

Dec

-14

Apr

-15

Aug

-15

Dec

-15

Apr

-16

Aug

-16

Aggregate ROE of Top 5 Indian IT service providers

Technology


TechM – resilient portfolio, internal margin levers TechM’s telecom segment (ex-LCC) appears to be insulated from macro-economic concerns based on our channel checks and commentary of its key customers and other stakeholders (e.g. Amdocs). Whilst management has not yet highlighted any concern on its non-telecom segment, it could be vulnerable to pricing pressure and/or revenue loss because it is sub-scale and lacks significantly differentiated capabilities. We have cut FY17-18 EPS estimates by 2-9% and reduced the target price to `580 (earlier: ̀ 650).

We like TechM because of its strong capabilities in the telecom segment (50% of revenues, top-3 globally and ahead of all Indian peers) as well as numerous internal margin levers such as offshoring, lower usage of subcontractors, improving employee productivity through re-use of code and low-level automation, and cost rationalisation at the recently acquired LCC. Its FY17 EBIT margin is about 600bps below its normalised target margin of 19.5%, which it last achieved in FY14. Over each of the past five quarters, adjusted for seasonal volatility, impact of currency movements and drag from LCC, margins have been steadily improved. In this context, current valuations are attractive at 12x one-year forward earnings.

Exhibit 19: Changes to key assumptions and estimates

New Old Change

` mn FY17 FY18 FY19 FY17 FY18 FY19 FY17 FY18 FY19

Telecom revenue (US$mn) 2,092 2,335 2,628 2,100 2,358 2,653 0% -1% -1%

Growth YoY -0.3% 11.6% 12.5% 0.1% 12.3% 12.5%

Enterprise revenue (US$mn) 2,163 2,360 2,604 2,195 2,430 2,682 -1% -3% -3%

Growth YoY 11.5% 9.1% 10.4% 13.1% 10.7% 10.4%

Revenues (US$mn) 4,255 4,694 5,232 4,297 4,795 5,346 -1% -2% -2%

Growth YoY 5.4% 10.3% 11.5% 6.4% 11.6% 11.5% USD/INR 67.0 67.0 67.0 67.4 67.5 67.5 -1% -1% -1%

Revenues (` mn) 285,160 314,528 350,562 289,658 323,691 360,834 -2% -3% -3%

EBIT (̀ mn) 38,157 45,607 52,584 38,824 50,452 56,232 -2% -10% -6%

EBIT margin 13.4% 14.5% 15.0% 13.4% 15.6% 15.6% PBT 42,204 48,553 55,884 42,872 53,398 59,531 -2% -9% -6%

EPS 35.3 41.1 47.3 35.8 45.2 50.5 -2% -9% -6%

Growth YoY -9% 17% 34% -7% 26% 12% Source: Company, Ambit Capital Research.

TCS – most resilient to tough times Despite high exposure to BFSI (40%), TCS is well-placed among peers to manage the headwinds in the demand environment due to its resilient portfolio mix (much higher proportion of revenue from annuity-like, run-the-business IT spend compared to peers), low-price-positioning (backed by best-in-class cost structure) and strong customer connect (it has over 37 US$100mn customers, more than 2x the nearest Indian IT competitor). We have, therefore, trimmed our FY17-18 revenue growth estimates only by 2-5%, lower than that for peers. The impact on margin expectations is also likely to be limited given its strong track record of maintaining/improving profitability even in adverse situations and because our channel checks indicate that it’s working on three margin levers (improving the employee pyramid, lower usage of subcontractors, and improving the revenue mix). See our note dated 28th July 2016 for more details. Therefore, we have trimmed FY17-18 EPS estimates by 2-5% and reduced target price to `2900 (earlier: `2950).

TCS remains well-positioned to gain market share (currently under 3%) in global IT services driven by low cost structure (ingrained in culture, best-in-class), conservative investments in new growth areas (e.g. Japan, automation) and track record of high quality delivery (has best customer references in almost every segment). Its processes and culture are hard to replicate, which ensures high RoE (FY16A: 37%). The business is also highly cash-generative (FY16 pre-tax CFO/EBITDA: 93%, FY16 FCF/Net income: 78%) which management is willing to share with investors (FY16 dividend pay-out: 57%).

http://reports.ambitcapital.com/reports/Ambit_TataConsultancyServices_WhyEBITmarginguidanceisreal_28Jul2016.pdf

Technology



New Old Change

FY17 FY18 FY19 FY17 FY18 FY19 FY17 FY18 FY19

Revenues (US$mn) 17,800 19,674 21,927 18,135 20,434 22,994 -2% -4% -5%


Revenues (` mn) 1,193,427 1,318,152 1,469,084 1,222,718 1,379,281 1,552,100 -2% -4% -5%

EBIT (̀ mn) 306,144 342,720 389,307 319,333 365,769 411,301 -4% -6% -5%

EBIT margin 25.7% 26.0% 26.5% 26.1% 26.5% 26.5% PBT 335,105 372,180 422,597 348,295 395,230 444,591 -4% -6% -5%

EPS 130 144 164 135 153 173 -4% -6% -5%

Growth YoY 17,800 19,674 21,927 18,135 20,434 22,994 -2% -4% -5%


Infosys – vulnerable in the near term, but no change to turnaround story Infosys is more exposed to headwinds in the demand environment compared to most large peers because its portfolio has a higher skew towards project-based, discretionary spend which can be quickly reduced if the customer’s outlook of its own business worsens. It also appears that recent order wins have been driven by its positioning as an innovation-led firm and Sikka’s CEO connect – advantages that are blunted when customers turn more price-sensitive under tough macro-economic conditions.

We have already seen the impact of one large project from RBS being cancelled (we estimate 1.5-2.0% impact to revenue) and at its recent analyst meet management warned of the possibility of cuts in revenues from other customers. Some recent senior management exits also bother us. So we have sharply cut our FY17-18 revenue estimates by 8-11%. Infosys has had a good track record of ensuring high profitability even in times of low negative growth. Further, management will likely scale back its aggressive investments (e.g. design thinking, automation, sales) to ensure that it meets its stated EBIT margin guidance of 24-25%. So our FY17-18 EPS estimate cuts are restricted to 3-12%.

We remain BUYers because the company continues to turn around (almost all operating metrics show improvement, channel checks also agree); and current valuations are attractive at 16x one-year-forward earnings, 10% discount to TCS. Also, we cannot rule out the possibility of Sikka’s super sales skills yielding large new deal wins even in the tough macro-economic environment.


New Old Change


Revenues (US$mn) 10,261 11,023 12,182 10,454 11,966 13,716 -2% -8% -11%


Revenues (` mn) 687,751 738,538 816,219 704,678 807,693 925,844 -2% -9% -12%

EBIT (̀ mn) 170,487 179,096 197,933 174,903 201,769 231,662 -3% -11% -15%

EBIT margin 24.8% 24.3% 24.3% 24.8% 25.0% 25.0% PBT 198,680 208,204 229,953 205,271 236,151 271,201 -3% -12% -15%

EPS 61.5 64.2 70.9 63.5 72.8 83.6 -3% -12% -15%

Growth YoY 4% 4% 10% 8% 15% 15% Source: Company, Ambit Capital Research.

Technology


HCLT – resilient portfolio, but recent capital allocation actions signal a desperation for growth HCLT has the highest exposure to IMS (40% of revenues) which should be most resilient to headwinds in the demand environment. We have reduced FY17-18 revenue estimates by 1-3% and our EBIT margin estimates by 30-50bps. So, we have cut FY17-18 EPS estimates by 3-6% and reduced our target price to `870 (earlier: `925).

We do note that recent capital allocation actions such as the acquisition of Geometric and a large software product from one of its customers signal to us desperation for growth. We are also worried about senior management attrition. For instance, Krishnan Chatterjee, former chief marketing officer and responsible for winning the prestigious ManU deal, quit recently and we hear rumours of other senior exits.

However, we remain BUYers because it has strong capabilities in IMS (world no. 2 ahead of all Indian peers) and engineering services (world no. 5, ahead of all Indian peers) which together contribute 58% of revenues. These strengths combined with its IP should ensure leading position in Internet-of-Things/automation era. Also, though some recent acquisitions have been questionable, it has had a good capital allocation track record over the past five years (FY11-16A average RoE of 30%). In this context, current valuations (13x one-year-forward earnings) more than price in the negativity.


New Old Change


USD/INR 67.0 67.0 67.0 67.4 67.5 67.5 -1% -1% -1%

Revenues 6,935 7,665 8,694 7,004 7,901 9,043 -1% -3% -4%

Growth YoY 11.2% 10.5% 13.4% 12.3% 12.8% 14.5% -1% -2% -1%

Software 3% 5% 9% 4% 8% 11% -1% -3% -3%

Infra 27% 15% 16% 28% 16% 16% -1% -1% 0%

Engineering and R&D 6% 11% 15% 7% 14% 15% -1% -3% -1%

BPO -13% 14% 17% -13% 15% 17% 0% -1% 0%

EBIT 1,363 1,456 1,695 1,402 1,542 1,766 -3% -6% -4%

EBIT margin 19.7% 19.0% 19.5% 20.0% 19.5% 19.5% PBT 1,518 1,614 1,871 1,557 1,698 1,941 -2% -5% -4%

EPS (`/share) 56.6 60.1 69.7 58.4 63.7 72.8 -3% -6% -4%

Growth YoY 8% 6% 16% 11% 9% 14% Source: Company, Ambit Capital Research.

Wipro – lacks the DNA of vertical domain expertise Wipro is highly exposed to headwinds in the demand environment because of its weak portfolio mix (even its IMS segment has large parts of project-based work) and weak customer-connect (until recently, its relationships managers were rotated every 18 months). To add to its woes, the CEO is also new. We have slashed FY17-18 revenue growth estimates by 2-7% and EBIT margin estimates by 70-100bps. This implies reduction in our FY17-18 EPS estimates by 6-11% and target price to `480 (earlier: ̀ 550).

Whilst the company is taking the right steps (corrected organisational structure, focus on building annuity-like revenue), problems of portfolio mix and culture (highly silo-ed, does not have the DNA of vertical domain expertise which is crucial today) are hard to change overnight. We maintain our SELL stance.

Technology



New Old Change


IT services

Revenues (US$mn) 7,752 8,057 8,745 7,929 8,663 9,594 -2% -7% -9%


Revenues (` mn) 521,123 539,811 585,923 535,944 584,779 647,575 -3% -8% -10%

EBIT (̀ mn) 91,017 97,166 108,396 97,653 111,143 126,337 -7% -13% -14%

EBIT margin 17.5% 18.0% 18.5% 18.2% 19.0% 19.5% Consolidated Revenues (` mn) 543,946 561,981 608,092 563,077 611,258 674,054 -3% -8% -10%

EBIT (̀ mn) 88,919 93,308 104,537 96,417 108,581 124,050 -8% -14% -16%

EBIT margin 16.3% 16.6% 17.2% 17.1% 17.8% 18.4%

EPS 33.6 35.5 39.7 36.0 40.4 45.8 -7% -12% -13%

Growth YoY -7% 6% 12% -1% 12% 14% Source: Company, Ambit Capital Research.

Technology


Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research Analysts

Name Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected]

Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected]

Abhishek Ranganathan, CFA Retail (022) 30433085 [email protected]

Achint Bhagat, CFA Cement / Home Building (022) 30433178 [email protected]

Anuj Bansal Mid-caps (022) 30433122 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected]

Deepesh Agarwal, CFA Power Utilities / Capital Goods (022) 30433275 [email protected]

Dhiraj Mistry, CFA Consumer (022) 30433264 [email protected]

Gaurav Khandelwal, CFA Automobile (022) 30433132 [email protected] Girisha Saraf Mid-caps / Small-caps (022) 30433211 [email protected]

Karan Khanna, CFA Strategy (022) 30433251 [email protected]

Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Paresh Dave, CFA Healthcare (022) 30433212 [email protected]

Parita Ashar, CFA Metals & Mining / Aviation (022) 30433223 [email protected]

Prashant Mittal, CFA Strategy / Derivatives (022) 30433218 [email protected]

Rahil Shah Banking / Financial Services (022) 30433217 [email protected]

Rakshit Ranjan, CFA Consumer (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritesh Gupta, CFA Oil & Gas / Chemicals / Agri Inputs (022) 30433242 [email protected]

Ritesh Vaidya, CFA Consumer (022) 30433246 [email protected]

Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Sagar Rastogi Technology (022) 30433291 [email protected]

Sudheer Guntupalli Technology (022) 30433203 [email protected]

Sumit Shekhar Economy / Strategy (022) 30433229 [email protected]

Utsav Mehta, CFA E&C / Industrials (022) 30433209 [email protected]

Vivekanand Subbaraman, CFA Media (022) 30433261 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7886 2740 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Hitakshi Mehra India (022) 30433204 [email protected]

Krishnan V India / Asia (022) 30433295 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Shaleen Silori India (022) 30433256 [email protected]

Vishal Mehta India / Asia (022) 30433198 [email protected]

Singapore

Pramod Gubbi, CFA – Director Singapore +65 8606 6476 [email protected]

Shashank Abhisheik Singapore +65 6536 1935 [email protected]

USA / Canada

Ravilochan Pola - CEO Americas +1(646) 361 3107 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Jestin George Editor (022) 30433272 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]















































Technology


Tata Consultancy Svcs Ltd (TCS IN, BUY)

Source: Bloomberg, Ambit Capital research

Infosys Ltd (INFO IN, BUY)


Tech Mahindra Ltd (TECHM IN, BUY)


HCL Technologies Ltd (HCLT IN, BUY)


0

500

1,000

1,500

2,000

2,500

3,000

Aug

-13

Nov

-13

Feb-

14

May

-14

Aug

-14

Nov

-14

Feb-

15

May

-15

Aug

-15

Nov

-15

Feb-

16

May

-16

Tata Consultancy Services Ltd

0200400600800

1,0001,2001,400

Aug

-13

Nov

-13

Feb-

14

May

-14

Aug

-14

Nov

-14

Feb-

15

May

-15

Aug

-15

Nov

-15

Feb-

16

May

-16

Infosys Ltd

0100200300400500600700800

Aug

-13

Nov

-13

Feb-

14

May

-14

Aug

-14

Nov

-14

Feb-

15

May

-15

Aug

-15

Nov

-15

Feb-

16

May

-16

Tech Mahindra Ltd

0

200

400

600

800

1,000

1,200

Aug

-13

Nov

-13

Feb-

14

May

-14

Aug

-14

Nov

-14

Feb-

15

May

-15

Aug

-15

Nov

-15

Feb-

16

May

-16

HCL Technologies Ltd

Technology


Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation

UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events

NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock POSITIVE We have a positive view on the sector and most of stocks under our coverage in the sector are BUYs

NEGATIVE We have a negative view on the sector and most of stocks under our coverage in the sector are SELLs

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Technology


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Documents

TECHNOLOGY - Ambitreports.ambitcapital.com/reports/Ambit_Technology_Thematic_Roll... · Infosys and Wipro see the ... (e.g. recent pre-results warning by Mindtree, project cancellation