IT catches Covid-19 bug: Sector's outlook takes a hit on demand concerns

Information Technology (IT) stocks, which were considered as ‘defensive’ until recently, have been under heavy pressure due to demand concerns caused by the outbreak.

The Nifty IT index has shed close to 20 per cent in a month, in line with the Nifty50. The expected earnings pressure, mainly on account of a tepid top line, is weighing on sentiment.

Analysts expect top line pressure to start reflecting from the March quarter itself, given the supply-side disruption amid the lockdown and business disruption in key markets such as the US and Europe. Besides lower billing and utilisation (lower productivity on account of travel restrictions), the disruption will also hit margins, despite a sharp depreciation in the rupee.

The major impact will be felt in H1FY21 (April-September 2020), with demand from clients expected to be sluggish. This will hurt earnings visibility for the entire FY21, given the first half is typically vital for the sector. This is when most of their clients announce their IT budgets.

Therefore, analysts at HDFC Securities have slashed their earnings estimates by up to 12 per cent for top IT players, and by a sharper (up to 28 per cent) magnitude for mid and small IT companies.

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According to Sanjeev Hota, head (research) at Sharekhan: “The rapid spread of the virus has caused disruption in the supply side, and is likely to impact demand in the near term, driven by the cut in discretionary spending by clients, lower billing, and pricing pressure.”

This will impact IT firms’ financial services segment (mainly on account of lower global interest rates) and the retail sector, and consequently take a toll on overall revenue growth, as these two segments contribute 30-45 per cent to revenues of most players. Other analysts expect no growth in 2020-21 (FY21).

Besides, deal execution and new deal wins are likely to take further hit, as travel restrictions are expected to continue even after the lockdown. Thus, the revenue growth guidance for FY21 by IT firms is likely to be the lowest in many years.

Recently, Accenture — which follows a July-August accounting period — had cut its 2019-2020 revenue growth guidance sharply to 3-6 per cent, from 6-8 per cent earlier, due to the impending two-quarter (April-August 2020) coronavirus impact.

Analysts at Phillip Capital say Indian IT companies’ FY21 financials will face double the hit Accenture has.

While the extent of the lockdown is uncertain, analysts expect gradual recovery to start from Q3FY21. However, once the situation normalises, IT spends are likely to see a sharp recovery, with increased demand for Cloud migration, network management, and security, etc.

For now, investors are recommended to wait till clarity emerges on client spending.

Cyient, TCS slip over 0.5% amid report Boeing 737 Max crisis to hit IT cos

Shares of major information technology (IT) companies were trading lower in the early trade on Friday after a report said IT outsourcing contracts of more than $1 billion currently executed by Indian companies are at risk of termination because Boeing has halted the production of its flagship Boeing 737 Max jets with effect from January.

At 09:30 am, Tata Consultancy Services (TCS) was trading 0.6 per cent lower at Rs 2,188 apiece on the BSE while Cyient slipped nearly a per cent to Rs 405. HCL Technologies was trading flat with negative bias at Rs 560, down 0.14 per cent and L&T Technology Services was at Rs 1,488, up 0.27 per cent. Infosys too was trading 0.1 per cent higher at Rs 730. The S&P BSE Information Technology index was trading 0.18 per cent down at 15,520 levels. The benchmark S&P BSE Sensex was trading over 100 points or 0.26 per cent up at 41,272 points.

According to the report, firms such as TCS, HCL Tech, Infosys, Cyient, and L&T Technology Services have direct exposure to Boeing or its suppliers’ ecosystem, which comprises engine manufacturers, body suppliers, and avionics providers.

“Boeing figures on the top ten list of many Indian service providers. So, those players will definitely be affected in the short run. But the larger issue is if Boeing is hit, overall spending in the aerospace segment will also come down,” said Pareekh Jain, an IT outsourcing advisor and founder of Pareekh Consulting. 

According to estimates, the aerospace engineering outsourcing market worldwide is estimated at close to $4 billion per year, which is equally contributed by Boeing and Airbus. Of the $2 billion of IT works outsourced by Boeing, Indian service providers get mostly half the deals every year.

Among the global service providers, Accenture and Capgemini lead the list.

“Usually outsourcing contracts have safeguard clauses, which are likely to protect IT firms from losses (in the case of termination). But, profitability will definitely be hit in the short run,” the report added quoting Sanchit Vir Gogia, founder and CEO, Greyhound Research, as saying.

IT stocks drop as brokerages raise concerns; Nifty IT index falls 2%

Shares of information technology (IT) services companies fell on Friday, after analysts said the industry’s growth momentum faces headwinds in the form of weakening macro indicators. The Nifty IT index fell 2 per cent, the most in a month. In comparison, the benchmark Nifty fell less than half a per cent.

All the 10 components of the Nifty IT index ended with losses, with industry leaders Infosys and Tata Consultancy Services (TCS) leading the decline. Infosys fell as much as 4 per cent, while TCS fell nearly 3 per cent before recouping some of the losses.

“We already see signs of year-on-year (YoY) growth moderation in the past two quarters. The trend is likely to accelerate, as weak macro translates into slower demand, ongoing pressure on the higher legacy business (about 65 per cent of revenue), and the benefits from large deals (lumpy in nature) wane in coming quarters,” wrote Nomura in a note on Thursday.

The brokerage said signals from the United States (US) — the biggest market for domestic IT companies — aren’t encouraging. “We see further weakening of the macro indicators in the US, with Street GDP forecasts moderating, CEO confidence at a 3-year low, services PMI below 50, and manufacturing PMI showing deceleration signs lately.”

Nomura said that even Europe — which is another key market — is showing signs of weakening.

The brokerage said barring a few verticals such as the US banking and financial services (BFS), consumer and healthcare, all other verticals are showing moderation in IT spends.

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“Retail growth and profitability are impacted by structural issues at store retailers. Oil and gas, after two years of strong momentum, is seeing weakness due to lower crude oil prices. BFS Europe and capital markets are impacted by the macro, Brexit risks and falling interest rate environment. Within manufacturing, hi-tech and aero sectors have seen a sharp deceleration lately and auto continues to be impacted by the US-China trade war concerns and Brexit,” the brokerage said. While growth is slowing, there is little valuation comfort as the IT pack trades at a premium to its long-term average, indicating scope for moderation in stock prices.

“Tier-1 IT currently trades at 19.3x one-year forward earnings (our estimate), and is at an 8 per cent premium to its five-year average. We think valuations are not cheap, given the slowing YoY revenue growth and moderating margin profile,” said the brokerage. In 2019, the IT index has underperformed the benchmark Nifty, with the former gaining 3.5 per cent and the Nifty advancing 10 per cent.

Other defensive sectors such as FMCG and pharma have underperformed the IT index this year.

IT stocks currently trade at a 7 per cent discount to Nifty. Historically, they have traded at a 2 per cent premium to the benchmark index. When compared to other defensive sectors, IT trades in line with historical discounts to FMCG and lower discounts to pharma.

Sensex ekes out weekly gain

Indian shares capped a fourth week of gains, but barely, as investors mulled the domestic economic outlookand awaited further details on the US-China trade discussions. The Sensex fell 0.5 per cent on Friday to 40,359, narrowing its full-week increase to 0.01 per cent. The Nifty Index dipped 0.5 per cent. The weekly advance was driven by a sharp rise in telecom stocks on Monday and Tuesday. Meanwhile, Sensex components have been rejigged. Titan, UltraTech Cement and Nestle India will be added to the benchmark Sensex. Meanwhile, Tata Motors—both ordinary and differential voting rights (DVR) shares, Vedanta and YES Bank have been removed from the index. The changes will become effective from December 23. Analysts said following the changes, the price-to-earnings multiple of the index could go up, while aggregate revenue could shrink.

IT firms may shed 5-10% mid-level workforce, focus on digital: Infy ex-CFO

Information technology companies in the country have no choice but to lay off at least five to ten per cent of their middle-level staff to ward off margin pressure and become more agile, IT industry veteran V Balakrishnan said on Thursday.

The middle-layer accounts for about 20-30 per cent of the total workforce of IT companies.

The former Chief Financial Officer of software giant Infosys Ltd said the companies have no choice because they all have built a lot of fat in the middle, so they have to reduce it and become more agile.

"Also, they have to get employees who understand new technologies, they have to get rid of some of the employees, who are more on the legacy, and try to attract talent which is more digital, that has to happen, there is no choice", Balakrishnan told PTI.

Asked if other companies would follow suit after lay-offs at Cognizant and Infosys, he said they have no choice, because there was lot of pressure on the margins.

"When you go more on the digital side, customers are also becoming more conscious about the cost. On the other side, you have to become more agile, cut all the flab, that's (lay-offs) inevitable, that will happen with all companies", Balakrishnan said.

However, he said, the growth of Indian IT services companies in general in the calendar year 2019 has been stable with reasonable growth. There were fears of slowdown in the global economies but that impact has not been seen.

"Digital is driving growth. With new technologies, most of the companies are reconfiguring themselves, focusing on digital and also reducing the flab with legacy technology employees and trying to be more cost-effective and having a better pyramid," he said.

"So, it's a combination of both. Focusing more on digital, that's where the growth is, and also reconfiguring employees and slowly moving away from the legacy technologies," he added.

On the prospects of IT services companies in 2020, he said all the global economies seem to be stable and there are no fears of recession.

If they play the game properly, it would be a good year for them as there are no concerns, Balakrishnan added.

IT midcaps tap into transformational deals, digital play drives higher TCV

Transformational deals, earlier a preserve of Information Technology (IT) large caps, are trickling into the midcap space with increasing number of players reporting transformational and incremental deals from existing customers. For some companies, the last quarter of the financial year (FY) 2019 saw a slew of transformational deals coming in from across sectors.

In the January- March quarter, Larsen & Toubro Infotech (LTI) reported multi-year multi-million dollar transformation deals with an engineering equipment manager and a reinsurer which helped the company poakcet a total contract value (TCV) of over $100 million. Hexaware reported a quarter of largely customer transformation and cloud deals unlike the automation-heavy deals of the past. Pune-based Zensar reported strong growth driven by healthy deal wins as well.

A Gartner report says it's not true that bigger players alone drive transformation. If the scale of transformation is big, however, the bigger ones have better capacities compared to midsized players as it requires a significant investment. “We now see more demand for midsized players as they can bring more value for money. Many midsized companies now have the ability to differentiate themselves from the rest as they bring innovative solutions and services for customers,” said D D Mishra, Senior Director Analyst, Gartner.

The report notes that customers in mature markets are dealing with a higher number of relatively-unknown players than established ones. Consequently, projects have evolved towards service integration management (SIAM) and Multisource Service integration (MSI) models, which are gaining in popularity.

Midsized players are often the part of an ecosystem, with large players trying to complement rather than compete. These changes make midsized organisations and startups more valuable and make them candidates for market consolidation, thereby driving more inorganic growth for some larger ones, said Mishra.

“Around 30-40 per cent deals signed by midcap IT service providers in the last eight quarters have elements of digital transformation or digital customer experience involved. The average deal size for these transactions was between $10-20 million with some providers signing contracts worth as high as $35 million or as low as $2 million in TCV,” said Vishwakumar Nandagopal, Director & head of India operations, ISG.

ISG also found that growth in contracts that involve midcap service providers are between 8 to 10 per cent, which is not very high growth compared to the traditional services growth.

Zensar reported $750 million worth of TCV in FY19 -- compared to about $500 million the previous year -- with 60 per cent of the deals being $10-million plus across verticals. A third of these deals have a timeline of five to seven years.

"In order to be relevant (to customers), we underwent our own (digital) transformation. This has earned us customer trust. We see the trend of mid-size deals with increased deal volumes in the recent past. Pricing models are dependent on the outcomes customers are able to realize, which directly influences the deal value too,"said Sandeep Kishore, CEO and MD, Zensar Technologies.

While these deals have continued the pressure on acquiring talent and subcontracting for these midcaps, the fact that many have moved out of PoCs to actual long-term deals bodes well for the players from a long term revenue perspective.

Sunil Sapre, CFO, Persistent Systems notes that with digital comprising 24.4 per cent of the revenue in Q4, it is clear that clients have moved beyond proof-of-concept projects. “Longer duration deals are coming in and transformational deals are happening,” said Sapre.

Apurva Prasad, AVP Research, HDFC Securities says that the market itself has expanded to provide midcaps more opportunities. “On one hand you have the backend and core transformation deals which drive value and there are the customer experience transformation deals that drive volume. Basically, the $10-25 million deal bracket has opened up, allowing midcaps to compete at par with large caps,” said Prasad.

That said, billion-dollar deals still continue to be a preserve of large caps like TCS and Infosys despite a few sporadic deals reported by other players.