Software & Services share price target

Our checks with IT companies suggest 1) Moderate acceleration in deal pipeline, 2) 5-20% increase in ACV of digital deals, 3) Growth in digital driven largely by existing logos (increasing stickiness), 4) Continuity in vendor consolidation, 5) Limited impact on service delivery from COVID-19 (but pipeline conversion uncertainty), 6) Deal sourcing strategy evolving with increase in non-RFP/higher POC conversion & more joint GTM with partners, and 7) Re-skilling & training reducing the demand-supply gap in new technologies, despite the supply shortage. IT sector is built to last and will navigate through the near-term economic shocks. We have observed improving structural trends in (1) Key demand drivers (performance and outlook of large enterprise clients for sector & company-specific), (2) Technology supply-chain (trends from leading global products & platform), and (3) Supply metrics (H-1B trends on wages, count & geo diversification).

The spread of Covid-19 has led to lockdowns in many countries globally and could have adverse economic implications. In addition, the recent fall in crude prices could also have an adverse impact of fiscal health of oil producing countries. As a result, IT companies, which have considerable exposure to verticals such as oil, energy & utilities; banking & capital markets; manufacturing and travel & transport could see an adverse impact from the ongoing crisis. Companies like Wipro, Infosys in large cap and MindTree, NIIT Tech, Sonata software, Cyient, Accelya Solutions among...

US banks had a good quarter & are more optimistic on revenue environment due to improvement of US-China trade discussions & bit uptick in consumer spending. Commentary of major banks like Citi, JP Morgan, BoA and Wells...

BFSI and Healthcare verticals continued to lag the overall growth with an unchanged' muted outlook, impacted by few large banking accounts (capital market segment). Within BFSI, growth was insurance-led; NorthAm large banks' outlook was less muted than Europe large banks that face bigger macro risks, yet stable budgets seen for CY20. Outlook for CMT vertical mixed with positive commentary for Communications segment (+ve for TechM), offset by content services business impact in Technology. CTSH lags industry growth impacted by BFSI, Healthcare verticals and CTSH-specific factors (business re-calibration following the leadership change). Our checks suggest no material increase in competitive intensity. Prefer INFY, HCLT and TechM from tier-1 IT. Cognizant (CTSH) posted revenue above its guided-band at USD 4.28bn, +0.8/3.8% QoQ/YoY (decelerated to +4.2% YoY CC vs. 5.1% YoY CC registered in 3Q). CY19 revenue stood at USD 16.78bn, 5.2% CC (includes 3.2% organic) and CTSH guided for 2-4% YoY CC (1-3% organic) after -110bps impact from the exit of certain content services business in CY20E. 1QCY20E revenue guidance stood at +2.8 to 3.5% YoY CC, which factors -60bps impact from content services.

EBIT margins were broadly in line across Tier-I companies. TechM was the only exception as it surprised negatively on the margins front (fell 60bps qoq), affected adversely by transition costs related to large deals. It is expected to undershoot its FY20 margin outlook. Order intake was weak, although companies remain confident about a pick-up in bookings in Mar'20 quarter, aided by pipeline. Companies continue to indicate increased targets of fresher hiring for FY21, providing further evidence around our sector thesis. We continue to expect a further moderation in growth for the IT Services sector as a whole....

Indian IT's increased investments in (1) Re-skilling, (2) Localisation/near-shore (HCLT - Canada, Lithuania; Wipro - Virginia, Melbourne), (3) Platforms and partnerships (HCLT-GCP; Wipro-Mulesoft) continue to augment its digital prowess with increasing penetration across the portfolio. Headwinds such as (1) Tighter cost controls by enterprises/clients (particularly in large BFS), and (2) Elevated onsite metrics (localisation, sub-contracting) persist. However, we expect a steady 2020 as reflected in strong deal pipelines and continuity in large deal wins (TCS-Phoenix, INFY-Telenet, Siemens, Arlanxeo, Wipro-Olympus) and stable outlook/guidance increase by Accenture. Revenue growth in our coverage universe in 3Q FY20 will remain steady (+1.7/7.6% QoQ/YoY vs. 8.3% YoY in 1HFY20) in a seasonally weak quarter. Margins are also likely to be steady supported by INR, cross currency (GBP), offset by furloughs and wage increase for select companies. Within the sector, tier-1 IT will deliver +1.6/7.5% QoQ/YoY (vs. 8.3% YoY in 1HFY20) and tier-2 IT is expected to post +2.1/7.9% QoQ/YoY (vs. 8.7% YoY in 1HFY20).

In the last three months, BSE IT index has underperformed SENSEX. Sensex has seen a gain of 8.1% vs. a 1.1% gain in case of BSE IT index. The IT sector continues to see headwinds from concerns over slower growth and upcoming elections in the US. In addition there has been negative news flow for stocks like Infosys (INFO). Q3FY20 has been another quarter of currency volatility cross-currency movement (positive for reported US$ revenue growth) and INR depreciation (positive on EBIT margin). Further, we forecast the divergence as regards revenue growth to continue in Q3. We forecast Tech Mahindra (TECHM) to outperform amongst large-caps with...

The dichotomy/mixed signals in the commentary between Indian IT (cautiously optimistic) and Global Tech (cautious) reconciles with the growth outperformance of Indian IT. Yet, despite the pivot to digital, there will be first among equals' within Indian IT as the global macros continue to be challenging (BFS, Retail). The investments in localisation, re-skilling, platform & partnerships and M&A to align with changing business and addressable market have supported growth, despite tight enterprise budgets. We hosted IT and New Age Business Investor Forum in Mumbai with 27 corporates/experts participating in the event. The participating corporates/experts were across the spectrum of (1) Largecap IT services (TCS, HCL Tech, Tech Mahindra), (2) IT/ER&D; midcaps & smallcaps (Mphasis, L&T; Tech, Mindtree, Tata Elxsi, Sonata, KPIT Tech, Intellect, Birlasoft, Mastek), (3) Exchanges & Staffing (MCX, CDSL, NSE, Quess, Teamlease) and (4) Tech experts (IBM, Capgemini, ex-Cognizant, Top-3 Cloud vendor, CRM/BPM, UiPath, Infor).

Our analysis of growth trends over the last 12 years indicates a risk of protracted near-term softness for India's IT services industry in the runup to US presidential elections in Nov'20.

Indian IT's digital prowess is gaining rapidly with increase in penetration across portfolio. This is augmented by increased investments in re-skilling, localisation, platforms and partnerships (TCS-Cisco CoE). While the demand environment is stable and deal wins continue to remain strong (TCS-GM, INFY-Toyota, HCLT-Aperam, TechM-AT&T), (1) Tighter cost controls by enterprises/clients and (2) Elevated onsite metrics (localisation, sub-contracting) are imminent growth/margin risks. Recent results and guidance from Accenture highlight (1) Continuity in deal booking strength, (2) Steady growth outlook for CY20, and (3) Challenges in Europe BFS. IT sector growth in 2Q is expected to mildly accelerate (at 2.9/9.1% QoQ/YoY) supported by acquisitions (IBM products, Stater contributing ~35% to sequential growth). Onsite investments, volatility in Fx and higher cost of delivery will casue YoY decline in margin (-162bps). Sequential improvement in operating performance supported by currency, absence of visa cost, offset by wage increase impact (INFY, Wipro, LTI, LTTS, Mindtree, Hexaware, Persistent, Zensar).