Majority of the end-user industries served by Indian IT companies are performing well. All companies have indicated bigger size of digital projects as clients appear clearer about their digital strategy.
IT industry leaders TCS and Infosys reported a decent set of numbers for a quarter that is traditionally a weak season. Volume growth and a slight improvement in margin were the positives. This apart, management commentary was quite encouraging. So what should investors make of this optimism?
Calendar 2018 to be better – say Infosys and TCS
Both TCS and Infosys were optimistic about deal flows, traction in digital as well bigger sized digital orders. But they differed in their outlook on the banking and financial services (BFS) segment, a big revenue grosser for IT firms.
Infosys attributed the weakness in BFS largely to seasonality, but TCS sounded less confident about things getting better anytime soon. The good news is that with retail making a strong comeback and energy sector getting a boost from rising crude oil prices, most verticals appear to be out of the woods.
Majority of the end-user industries served by Indian IT companies are performing well. All companies have indicated bigger size of digital projects as clients appear clearer about their digital strategy. Finally, clients which were spending money on reskilling of in-house resources are largely done with that and should now start giving more regular business. However, in-sourcing (where client uses its own resource or captive company) will continue to remain a potent competition for Indian IT players.
Accept single-digit growth
The days of industry leading growth for large-sized IT companies are largely over, given the transformative changes in the industry. In the first nine months of FY18, TCS has reported topline of USD 14.1 billion, registering a revenue growth of 7.6 percent in US dollar terms. Over this period, its peer Infosys has reported revenue of USD 8.1 billion – a dollar revenue growth of 6.5 percent.
Financial services remain a question mark
For Infosys and TCS, BFS has traditionally been the dominant segment (nearly one-third of total revenue) and the same is on a slow lane. While Infosys attributed the weakness to seasonality - higher furloughs and holidays; TCS has blamed it on a change in sourcing mix of select US banks. TCS expects the impact of this to reduce but only after two quarters at the earliest. It attributed the weakness to different stages of internal investment by US banks to get ready on digital technologies. Once this investment phase is complete, it expects more balanced spending between internal, captive and outsourcing players.
Margin maintained – but most levers getting exhausted
TCS and Infosys both managed to maintain their operating margins. However, doing so amid rising pricing pressure has exhausted most of the margin levers. For instance, Infosys’s utilisation level stands at a high of 84.9 percent and onsite mix at 29 percent is at an eleven quarter low. Unless remunerative digital ramp up happens faster and/or external factors like rupee depreciation aids margin, improving the same remains a challenge.
Volume pricing trade off
Both Infosys and TCS have reported healthy volume growth. However, they did experience a decline in realisation, perhaps on account of the sluggishness in legacy business which is still a substantial portion of the overall revenue.
Digital – promising but yet to assume critical mass
Both the leading IT service companies have made impressive strides in growing the digital business. For TCS, the digital portion has shown year-on-year growth of 39.6 percent and sequential growth of 13.9 percent (as against the company’s growth of 1.3 percent) and forms 22.1 percent of total revenue.
For Infosys, the digital revenue is close to 25 percemnt of revenue and its new services have shown sequential growth of 6.4% and new software of 7.3% (much higher than the overall growth of the company at 0.8%).
And yet, the digital piece isn’t sizeable enough to kick start a virtuous cycle which could fully offset the weakness in the legacy businesses.
Dividend yield – lucrative and protects downside
Both Infosys and TCS generate healthy cash flows, are cautious about acquisitions and now have a well-articulated cash distribution policy in place. Infosys, for instance, has a policy to return 50% of after-tax-profit or 70% of free cash flow to shareholders. In the current fiscal it just concluded Rs 13,000 crore buyback. An equivalent dividend payment works out to 4.4% dividend yield.
Even, TCS completed a Rs 16,000 crore buyback and paid dividend of Rs 47 per share in FY17. An equivalent dividend works out to a dividend yield of over 4%.
An improving outlook for IT spending for these companies coupled with a very respectable dividend yield should protect downside for these stocks.
But investors must brace for single-digit growth rates in the foreseeable future and accept the fact these are not “growth businesses” till then. If rupee depreciates, it could be an added sweetener.
TCS versus Infosys – what to bet on?
TCS has not yet articulated the impact of various tax changes in the US on its businesses (overall corporate tax rate has been reduced to 21% from 35% but there are new taxes) whereas Infosys has concluded an Advance Pricing Agreement with the US IRS (leading to tax reversal of $225 mn in the quarter and bump up in reported profit) and expects the overall tax changes to have a neutral impact on its tax rates.
Both Infosys and TCS have underperformed the benchmark in the past one year, although on relative terms Infosys has underperformed TCS on account of uncertainty pertaining to its top-management. With a new leadership in place, the news flow from Infosys is likely to be incrementally positive. Salil Parekh, the new CEO of Infosys will focus on key areas of new market opportunities, client relationship, people and service offering and lay down the strategic priorities for the company in April, 2018.TCS is at a 20% valuation premium to Infosys and if the new management of Infosys delivers without much hiccup, this premium might narrow. So on a relative basis Infosys might have a little more exciting journey ahead.