For the past few quarters, some of the large- and mid-tier IT services companies have been growing at a fair clip and bagging large deals. Digital deals have started to form a larger part of their revenues while core services for most large- and mid-sized players have seen tepid growth; most of the information-technology services companies’ revenue growth was supported by digital.
But the global economic slowdown and the US-China trade war have had a direct impact on many Indian IT services companies. Except for HCL Technologies, which has increased its revenue guidance (Infosys upped the lower-end of its revenue guidance), most Indian IT services companies have cut their FY20 guidances.
With the first half of FY2019-20 behind us and the global headwinds beginning to hit, let’s take a look at the IT services companies investors can bet on. But before we do that, it’s important to look at the levers pulling these companies in different directions.
Where is the slowdown?
One segment where client spends are slowing for almost all IT services providers is banking and financial services. Clients are delaying operationalising some deals that were signed in previous quarters. This is especially true of large banking deals in Europe and capital markets- related projects in the US.
While this slowdown might be transient in nature, it allows investors to take a peek at what the clients are thinking about the future prospects of the economy, and as an extension, its impact on IT services companies. Some mid-tier companies that have been growing at a faster pace than their larger peers, have been impacted by large clients delaying spends to achieve cost savings.
With respect to specific verticals, Infosys, TCS and Wipro saw weakness in client spends in banking, financial services and insurance (BFSI) which led to slower revenue growth in the quarter ended September 30. In the US, capital- market clients, in particular, are putting the brakes on the spends. But digital projects seem to be providing some succour to most players in this vertical.
Another vertical where revenue slowed in the quarter ended September 30 was manufacturing. The revenue growth of Tech Mahindra, Wipro and HCL Technologies slowed in this segment. Retail clients, such as large-format department stores, of the two largest IT services companies — Infosys and TCS — are holding back their spending, which has led revenues to slow sequentially in the September quarter.
Among the mid-sized IT companies, L&T Infotech has seen its banking and financial services vertical’s revenues slowing for the past three quarters. The segment makes up for nearly 27 per cent of the firm’s total revenues.
The company’s group peer L&T Technology Services’ revenues from the telecom and hi-tech verticals have been slowing for three consecutive quarters (its makes up for over 20 per cent of the firm’s revenues).
The retail, consumer packaged goods and manufacturing verticals of Mindtree, which is also part of the L&T Group now, posted a tepid growth for three consecutive quarters.
Regional performance
In terms of geographies, except for Infosys and HCL Technologies, growth in revenues from Europe seems to have slowed in the past few quarters for the large Indian IT players. The macro challenges in continental Europe — with its largest economy Germany slowing — have taken a toll. While TCS’ revenues from Europe have slowed, it’s tepid growth in North American revenues seems to have surprised investors — revenues from North America grew a mere 0.6 per cent during the September quarter to around $2.8 billion.
Wipro’s European revenues have been hemmed in for the past four consecutive quarters mainly because large banks have been delaying spends due to the uncertain economic environment. Revenue growth from Europe during the quarter was muted. However, the company’s North America revenues bounced back after a tepid June quarter.
Muted growth in its manufacturing vertical impacted Tech Mahindra’s Europe revenues. This in turn was impacted by the macro headwinds being faced in Europe, as the EU economy is slowing down in face of the US-China trade war. The firm’s European revenue growth also took a hit because of cross- currency headwinds.
However, after a couple of quarters of tepid growth, Americas helped Tech Mahindra grow in the September quarter — revenue from Americas grew 5.2 per cent to $ 624 million.
Infosys’ European revenues grew, helped by its acquisition of Stater (mortgage services provider) earlier this year, while HCL Technologies’ growth was helped in part by its acquisition of IBM suite of products, which it completed in the quarter ended September. HCL Technologies’ North America revenues were flat in the September quarter, growing just 0.1 per cent sequentially to $1.6 billion. Infosys posted a decent sequential revenue growth of 2.2 per cent in its North America revenues.
Steady margins
On the margin front, the September quarter was always going to be a tough one for IT players with pay hikes being doled out to employees. However, among the top IT companies, Infosys, Wipro, HCL Technologies and Tech Mahindra managed to increase their margins sequentially. A rise in sub-contracting costs for TCS led to margins falling quarter-on- quarter.
In the mid-sized IT space, Mindtree and Mphasis managed to better their September quarter EBIT (earnings before interest and taxes) margins compared with the June quarter. Hexaware Technologies, L&T twins (Infotech and Technology Services), among others, saw their margins shrink during the quarter. Most of these companies reported a fall in margins on a year-on-year basis due to a mix of rising sub-contracting costs and adoption of new lease accounting standards that led to higher amortisation expenses being recognised on the books.
Also, pay hikes doled out during the first half of 2019-20 impacted margins on a y-o-y basis. Both large- and mid-sized companies have hired a large number of freshers for future projects. Till the projects come on stream and the newly hired are aligned to those projects, there could be an impact on margins due to lower employee utilisation.
There have been news reports that many IT companies, including Infosys, are looking to cut the flab in their mid-level employee hierarchy. If so, it could help improve margins. The point to note here is that the quarter ending December usually sees many employees in the US take off on furlough, which could also shrink margins a bit (this has an impact on revenue as well).
Attrition in check
Infosys’ attrition levels have been above 20 per cent for three consecutive quarters now. In the quarter ended June (seasonally higher attrition), the number had spiked to 23.4 per cent. The management has assured that it would try to curb the runaway attrition rate of employees.
Higher attrition pulls down margins as companies have to hire from outside the company to meet short-term demands for talent. This also leads to an increase in sub-contracting costs. TCS’ attrition is one of the lowest in the industry and has been hovering at 11.2-11.6 per cent over the past four quarters. The company is training its employees in digital technologies and has been busy hiring people to meet its future needs when projects come on stream.
Wipro has managed to bring down its attrition to 17 per cent, from nearly 17.9 per cent in the quarter ended December 31, 2018. Tech Mahindra’s attrition has stayed constant at 21 per cent for four consecutive quarters — it’s one of the highest in the industry, just below Infosys. The company’s sub-contracting costs have been rising for five consecutive quarters — it rose 12.2 per cent sequentially in September.
Among the mid-sized IT companies, the hostile takeover of Mindtree by Larsen and Toubro caused disruption and saw many senior employees leave. This can be seen in the steady rise of Mindtree’s attrition rate, from 13 per cent in September 2018 to 16.5 per cent in September 2019. The hope is that now with the takeover complete, the management would tackle this spike in attrition as it could impact margins going forward.
Hexaware has managed to bring down its attrition rate to 17.3 per cent. It had been hovering at 18.2 per cent for the past two quarters. L&T Infotech has seen its attrition spike in the September 2019 quarter to a 12-quarter high of 18.4 per cent, while its group peer L&T Technology Services has seen its September quarter attrition come in at a seven-quarter low of 13.4 per cent.
Some big deal wins
The deal pipeline of most IT companies does reduce some of the pessimism about their prospects. But most of the pessimism has already been built into the stock prices.
Of the large IT companies that declared the value of deals signed in the September quarter, TCS bagged $6.4 billion, Infosys $2.8 billion and Tech Mahindra its highest ever quarterly deals of $490 million.
Among the mid-sized firms that declared the value of the deals they bagged in the September quarter, L&T Infotech won deals worth $ 100 million, Mindtree $307 million and Hexaware won net-new deals of $36 million (excluding renewals). The point to note here is that these deals — many of which relate to digital transformation — are a necessity. The clients might postpone the spends in face of uncertainty and macro headwinds, but these deals are eventually essential to the clients’ businesses as they will improve efficiency of operations. As an when the deals ramp up, there will be an increase in revenue visibility.
Stocks to bet on
The BSE IT index has had its ups and downs over the past 12 months despite rising 10.6 per cent over the period. Compared with their respective three-year trailing price-to-earnings (PE) multiples, HCL Technologies, Infosys, TCS, Tech Mahindra and L&T Infotech are all trading at a higher 12-month trailing PE multiple. But Wipro, Mindtree, L&T Technology Services, Hexaware Technologies and Mphasis’ 12-month trailing PE are below their three-year average PE.
While picking stocks to invest in the IT sector, it is important to note the cash flow conversion of the companies and the amount of cash these companies return to investors. A high dividend- yielding company, such as TCS, despite being more expensive than its peers, is any day better than one that has lower conversion of profits into cash.
That’s one of the reasons why TCS trades at such a premium to rest of the pack. HCL Technologies, despite its double-digit revenue growth, is valued at a discount to TCS. One of the reasons is the lower conversion of profits to operational cash flow.
TCS’ diverse capability to implement projects in various domains also helps it stand out, but its revenue growth expectations have come a cropper in 2019-20 due to a tepid first half. However, even though we don’t have a call on TCS, it’s still a good bet for investors because of its high payout ratio (80-100 per cent of free cashflows.) This is what keeps its price elevated compared with its peers.
HCL Technologies is also a good pick because it has managed to organically grow in double digits even with macro headwinds, and has upgraded its revenue guidance after the first half of 2019-20. Investors can consider buying TCS and HCL Technologies in the large-cap space and L&T Infotech and Mphasis in the mid-cap space.