Published on 14/02/2017 4:11:41 PM | Source: Religare Capital Markets Ltd
India IT Services - Downgrade cycle bottoming; valuations cheap - RCML
The RCML IT universe saw Q3FY17 revenue growth of 1.3% QoQ (RCMLe 1.1%) and EBIT margins of 21.3% (RCMLe: 21.2%). While Q3 was expected to be slow, our IT universe largely met estimates or outperformed slightly. We think earnings expectations for the sector have moderated and Q3 results indicate a bottoming out of the earnings downgrade cycle. Valuations are cheap and greater comfort on estimates leads us to turn constructive on the sector. We upgrade TCS, TECHM and WPRO from SELL to HOLD.
* Q3FY17 – IT beginning to meet expectations:
The RCML IT universe reported rupee revenue growth of 1.3% QoQ and 9.2% YoY for Q3FY17, marginally better than estimates. EBIT margins averaged at 21.3%, in line with our estimate of 21.2%. However, PAT growth (6.8% YoY) continued to lag revenue growth due to softer margins and lower yield on cash.
* Improving confidence on earnings estimates (ex-immigration bill):
The Indian IT sector has been seeing earnings downgrades over the past 1-2 years driven by growth and margin concerns. However, with current earnings expectations substantially moderating, we estimate only 6% Profit CAGR over the next two years for the sector. While the US immigration bill remains an event risk to earnings, we don’t expect any material earnings downgrades for the sector post Q3.
* Taking out our large-cap SELLs:
We believe earnings expectations have moderated for the sector and valuations (at 13x-17x FY18) are cheap given strong cash generation. We note that some large-caps are trading at 5-7% earnings yield, leaving room for capital allocation-led upsides for shareholders. We thus upgrade TCS, TECHM and WPRO to HOLD from SELL but downgrade FSOL to HOLD from BUY on limited upside potential. Within mid-caps, we like MPHL and would be buyers on declines. We maintain BUY on INFO and HCLT.
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