Published on 3/01/2018 4:07:37 PM | Source: Kotak Securities Ltd

Technology : 3QFY18 preview - Kotak Sec

Posted in Broking Firm Views - Sector Report| #Kotak Securities Ltd #IT Sector #Sector Report

December 2017 quarter revenue growth is likely to be soft, a seasonal trend. We estimate 1-1.8% organic c/c revenue growth for Tier I Indian IT. Mid-tier companies will report higher growth powered by a ramp-up in deals won. Investors are likely to focus on CY2018 demand outlook and more importantly, on industrialization of digital services and participation of Indian IT in the same. We see enough reasons to be optimistic on demand and revenue acceleration, though implications of US tax reform and potential changes to visa rules in US remain an overhang. 

December 2017— seasonally soft on expected lines; expect mid-tiers to outperform Tier I ITs We expect muted revenue growth for Tier 1 players due to the usual end-of-the-year furloughs and continued softness in BFS and North America. Cross-currency impact will be negligible for companies (exception Wipro) as most currencies have moved in a narrow range during 3Q. C/c headwind for Wipro could be high at about 100 bps due to the difference between exchange rates used for guidance and Dec 2017 quarter average rates. Mid-tier companies in our coverage (except Hexaware) will report strong growth powered by a ramp-up in deals won. Hexaware will report weak growth due to client-specific challenges in a couple of large accounts. 

Margins—steady on a quarterly basis; down on annual comparisons We expect margins to be flat or up on a sequential basis for Indian IT companies. There is no specific margin headwind/tailwind. Tier I IT companies should be able to offset the adverse impact of furloughs on margins through operational efficiencies. Mid-tiers with favorable growth momentum are well-placed to defend/expand margin. We expect 0-25 bps margin expansion for Tier I Indian ITs. Among other companies, Tech M and Mindtree will report strong 90-140 bps expansion in EBIT margin, largely driven by improving profitability of subsidiaries and non-recurrence of one-time costs, respectively.

CY2018—industrialization of digital services critical for acceleration in growth  Revenue growth decelerated in CY2017 on account of (1) lackluster growth in BFS, regulatory issues in US healthcare and challenges in retail vertical, (2) change in sourcing strategy of clients (higher insourcing), and (3) slow progress on digital and sub-optimal participation of Indian IT. It is difficult to forecast the first two factors, though we believe it likely that they may stabilize and cease to drag growth further. Investor focus will be on (1) CY2018 IT budgets and demand outlook, especially in case of drag verticals of CY2017, and (2) pick-up in digital spends—essentially, industrialization of digital services. Whether or not it drives growth acceleration for Indian IT companies would depend on the strength of each Indian IT company and the vendor sourcing strategies of clients. These factors keep afloat the hope of growth pick-up and offer reason to stay optimistic on CY2018 growth. We expect divergence in performance of companies depending on the mix of business (Run versus Change) and ability to capitalize on the digital opportunity.

Other areas of investor focus— implications of US tax reforms and H-1B dependency The imposition of Base Erosion and Anti-abuse Tax (BEAT) on payments made by US companies to its foreign affiliates will impact select Indian IT companies, more than offsetting gains from the lower corporate tax rate in the US. Tax implications will vary across companies depending on whether a company operates as per branch structure (negligible impact for Infosys, Wipro and Tech M) or subsidiary structure (some earnings headwind for TCS and HCLT). Separately, investors may also focus on H-1B dependency as one cannot rule out some change in US visa regulations in 2018. Indian IT stocks have performed well over the past few weeks. Further, stock performance is contingent on comfort on growth outlook and these two factors.


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