Published on 10/05/2017 12:17:15 PM | Source: Motilal Oswal Securities Ltd

IT Sector Update Risks to strong 1H seasonality - Motilal Oswal

Posted in Broking Firm Views - Sector Report | #IT Sector #Motilal Oswal #Sector Report


Risks to strong 1H seasonality?

* INFO’s 6-8% YoY guidance for FY18 embeds a normal seasonality with stronger 1H v/s 2H. Expectations from TCS are no different.

* CTSH interestingly cited that while 2Q is among the stronger quarters, guidance of 2.2-3.7% QoQ (and 7.7-9.2% YoY) does not reflect any worries on the demand outlook. Instead, this is a peculiar quarter where the number of working days in 2Q is lower than that in 1Q, a first in many years! That is playing a part in guidance for 2Q. Does CTSH’s outlook suggest some caution in baking higher growth rates for 1QFY18 for Indian IT? Something to ask the companies in coming days.

 

The law of large numbers? Looking beyond top verticals for high growth…

* BFSI and Healthcare, two verticals which contribute quarterly revenues in excess of USD1b for CTSH, grew in single-digits in 1Q, while other verticals grew in excess of 16%.

* On a higher base, even for TCS, growth has gotten choppy in recent quarters in verticals such as BFSI and Retail. Is the game shifting to the verticals outside the bread-n-butter, which could define relative outperformance?

 

Margin expansion – could the choice of period be any tougher?

* With downwards pricing spiral in traditional services, onsite centricity and lower margin in Digital (today) and the recent strengthening of the INR, margin commentaries across the top tier are turning cautious.

* While CTSH faces the same set of pressures, it has shed some more light on plans to inch up to 22% operating margin by 2019. It includes [1] Uptick in utilization, [2] Employee pyramid, [3] Cost efficiencies encompassing span of control, automation and vendor consolidation, among others. Notably, it also highlighted the focus on reassessing accounts yielding lower margins, offering little visibility for CTSH to further its Digital positioning.

* USD11m have been the costs incurred in 1Q in the form of advisory fees and severances towards cost optimization. More to come in the future quarters, despite which margins should improve by the quarter through the course of CY17.

* CTSH is perhaps chasing margins faced with the perfect storm of headwinds! It has indicated readiness to be more choosy when it comes to selecting business, raising more suspicion in our minds around just how possible is the duality of leading organic growth and margin expansion. It may well be a model to follow, if successful. Next few quarters will tell, but does not appear a given by any means.

 

H-1B - Either revenue growth or margins braced for impact?

* Similar comments have been made by the top tier on the use of H-1B visas. TCS’ visa applications were down to a third, INFO intends to add 10,000 locals over next two years and CTSH cited it hired ~4,000 locals in CY16, a number that will continue to significantly ramp up. The number of visas applied for this cycle is less than half that of the previous cycle. And this is expected to reduce further.

* Interestingly, CTSH refrained from alluding to more offshore skew as an option to offset the costs. It cited that the onsite-offshore mix is optimal, as some increase in traditional services will be offset by greater onsite proportion of work in newer areas like Digital.

* The explanation of such prolific use of visas all these years was the supply constraint in the US. If these biggest firms are able to seamlessly replace the workforce with locals in line with their targets, it ascertains that numbers in the US were not really the problem. That then means that either it is the flexibility of the local workforce, or the higher costs. If it is the former, then the now welcome local workforce should be a cultural challenge to the onsite engine - implying revenue uncertainty, or a margin challenge if will have to offset the same with higher bench at onsite. If the problem was the latter (costs), then again brace for the margin impact.

 

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