Motilal Oswal's report on IT sector
Strong guidance by even slower growing companies
- While 1Q revenue growth was in line (with only Tech Mahindra (TECHM) staging a positive surprise), outlook of even slower growing companies turned positive.
- The reinvestment of currency benefits is becoming visible across tier-II as well, imperative in our view for sustained growth.
- TECHM remains our top pick. Other picks in tier-II are PSYS and MTCL.
During 1QFY14, among tier-II stocks, TECHM was the only company which reported a positive surprise in revenue growth. However, even companies that were facing challenges to growth in the first half of calendar year have guided strongly, citing an uptick in the US and discretionary spending.
Growth polarization as evident in tier-II as in top tier
Assessing fundamentals bottom-up, growth outlook is sanguine at MTCL and PSYS. KPIT 's guidance is healthy considering its problem segments (SAP and Cummins India account for ~43% of revenue); however, we expect growth to be at the lower end of the guided band. While guidance at Hexaware improved, large deals conversion remains elusive, a concern on sustained growth. Expect growth at NIIT Technologies to be driven by India business, unlike peers.
Unexpected margin trends amid reinvestment of currency benefits
Margins were below estimate at MTCL and PSYS, notably two of the biggest beneficiaries of a depreciating currency, who clearly took the opportunity to reinvest the benefits in pursuit of higher growth. Going forward, ex currency, we see operating slackness to grow margins at PSYS, while MTCL guided strongly on profitability. KPIT and NITEC, the two companies where margins have been an issue, should be key beneficiaries from currency.
Tier-II valuation and view: TECHM remains our top pick
"We do not believe that there is a case for Tier-II's valuation discount to Tier-I to converge in the near-to-medium term due to:  similar growth rates to Tier-I despite being only a fraction of their revenue base,  much lower profitability, due to scale and  even lower cash generation, on account of higher capex intensity, which comes more from acquisitions than from scale. Hence, we adopt a bottom-up approach to choose mid-cap and TECHM remains our top pick, given our expectation of further re-rating, as the merged entity continues to address portfolio issues, while executing strongly in an improving environment. Among others, we prefer PSYS and MTCL for  greater earnings sensitivity to currency movements,  expectations of strong revenue growth going forward, and  better financial metrics v/s peers," says Motilal Oswal research report.
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