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FY20 likely to be a year of growth moderation
We expect our coverage universe of mid-size IT Services companies (ex-Mindtree) to post aggregate revenue growth of 1.6% QoQ and 10.3% YoY in USD terms in Q4FY19. Barring Persistent Systems (PSYS) and Cyient where we expect sequential decline in revenues, other companies should report healthy growth in the range of 2.2-3.5% QoQ. EBITDA margins should decline sharply for PSYS (460bps QoQ) and L&T Infotech (140bps) and expand the most for Cyient (80bps). Companies with a higher exposure to BFSI like L&T Infotech (LTI), Mphasis and Hexaware are likely to witness higher volatility given mixed commentary on the vertical from larger companies and potential reversal of interest rate hike cycle in the US. Within that backdrop, our preference would be to own L&T Infotech on a relative basis. We would also want to own the negative earnings preannouncement driven dip in Cyient as we expect execution to recover in Q1FY20 and see considerable headroom for margin improvement over the medium term.
* Revenue growth to be healthy barring for PSYS and Cyient.
USD revenues are expected to decline by 4.1% QoQ for PSYS driven by weakness in IP revenues across product lines in the Alliances segment. Cyient is also expected to witness a revenue decline of 1.4% QoQ driven by deferral of deal closures in services and delay in a $5mn order delivery in DLM. Revenue growth should be strong for NIIT Technologies (3.5% QoQ) and should be healthy for LTI & L&T Tech Services (LTTS) as well at 2.5% QoQ on an organic basis despite the impact of client specific issues for each. Growth at Mphasis may get impacted somewhat on account of challenges in demand fulfillment driven by supply challenges in the US.
* Operating leverage to be absent across the board; INR appreciation and tight onsite supply chain to be the key margin drags.
We believe that supply side issues in the US will be a bigger challenge for mid-size companies impacting either fulfilment or profitability in FY20. EBIT margin is likely to decline by 150bps QoQ to 17.6% for LTI driven by investments in capacity and S&M (100bps impact) and INR appreciation (50bps impact). We would also expect EBITDA margin for PSYS to decline by 460bps QoQ given the flow-through impact of IP revenue weakness. Cyient should fare better on profitability despite revenue weakness given a richer mix (higher services) and absence of the impact of furloughs which had impacted EBITDA margin by 115bps QoQ in Q3FY19. Higher onsite costs and potentially higher magnitude of wage hikes may blunt the benefit of hedge gains on the FY20 margins for Mphasis.
* Recommend a mix of growth and value; macro and supply side the key risks.
Valuation is justifiably inexpensive for PSYS (14.2x FY20) and Cyient (12.8x FY20) where execution has been patchy and below expectations in FY19. We retain BUY on each though would expect catalysts to materialize sooner for Cyient where we expect execution to pick-up in Q1FY20 and see material headroom for margins to improve over the medium-term. PSYS is deep value trading at <11x FY21 EV/FCF, that too on likely conservative estimates. However, it is imperative to get confidence that worst is behind in the IP segment in Q4FY19 and to hear new CEO’s comments on strategic priorities and associated timelines before recommending the name more aggressively. We have BUY ratings on LTI, Mphasis and Hexaware as well. Growth visibility is high for LTI (14% for FY20) despite client specific issue in BFS with margins also having scope for stability around 17.5% in FY20/21 driven by pyramid optimization and fixed cost leverage. We have downgraded our view on revenue and margins for Mphasis modestly given supply side issues but see the same as adequately discounted in valuation of 14.3x FY21 P/E.
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