IIFL Sector Report: Indian IT – Re-rating on the...

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Table of Contents

NSE

Table of Contents Page No.

Sectoral Overview 2-8

Turbulence in the rear view mirror; Digital to be growth driver 3

Green shoots are visible 4

IMS to be driven by Next-Gen Infrastructure Outsourcing 5

ER&D to outpace overall industry growth 6

Infosys 10-14

HCL Technologies 15-19

Persistent Systems 20-23

Disclaimer 24

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Indian IT – Re-rating on the cards

Infosys– BUY

CMP Target Upside

1,188 1,379 16.1%

HCL Tech – BUY

CMP Target Upside

1,088 1,309 20.3%

Persistent Systems – BUY

CMP Target Upside

747 966 29.3%

Prices as on 23/04/2018

The Indian IT sector is poised to perform well over FY18-20E on the back of improving global macro environment. Revamp in IT budgets for BFSI and increasing adoption of digital technologies by Enterprises, indicate strong momentum for the overall IT sector. The depreciating trend of Rupee will comfort the margins of the IT companies. Other areas of opportunities include next-gen Infrastructure Outsourcing Services (ISO) and Engineering & Research Development (ER&D) services that will spur growth for companies with exposure to above segments. Moreover, TCS’ result beat, solid digital growth and positive guidance provides confirmation that the skies are clear for the Indian IT space. Better times and higher FCF distribution by companies would drive rerating of the sector. Traction in digital to fuel IT services growth

As per NASSCOM, the digital revenues of the overall IT exports have grown at 50.8% CAGR over FY16-18, driving overall export CAGR of 8%. Industry estimates suggest that digital component (exports) would grow at 27-30% in FY19E aiding 7-9% growth for the overall sector. ISG data provides proof that deal activity in Americas is on the up and pricing pressures have bottomed out. ISG global level data is indicating that incremental spends are moving towards digital and outlook for the industry is brighter vs. FY18.

Shift towards cloud would aid next-gen ISOs

Owing to adoption of hybrid cloud, management of hybrid cloud and higher focus on workplace services would mean that companies with value proposition and broad reach would perform well and benefit from higher growth in Infrastructure-as-a-Service (IaaS, growing at a robust pace).

ER&D services to benefit from increasing presence of GICs

ER&D services have been in demand on account of rising spends on IoT and need for customized products. The growing role of Captive centers in ER&D services and emergence of India as a hotspot for setting up of captives would result in third party engineering service providers benefitting from the growing trend of co-sourcing.

We prefer (1) Infosys – stability returning, focus on growing digital capabilities and unwarranted discount to TCS (value at 18.0x FY20E EPS), (2) HCL Tech – favorable growth profile vs. peers, IP partnerships (value at 17x FY20E EPS), (3) Persistent Systems – to ride momentum in digital, valuations attractive post correction (value the stock at 17.0x FY20E).

April 24, 2018

Analyst–Milan Desai

[email protected]

mailto:[email protected]

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Turbulence in the rear view mirror; Digital to be growth driver

Indian IT sector is expected to perform well over FY19E-20E, as the IT spends of corporations are looking up. This is owing to (1) improved global macro environment and (2) digital becoming mainstream. Moreover, Rupee in a depreciating trend augurs well for the IT sector.

As per NASSCOM, the Indian IT industry added USD13bn in FY18 to reach USD167bn revenues, up 8.1% yoy. Of the USD13bn incremental revenue, USD10bn came from exports, of which, USD9mn was digital. Further, digital component grew at 56.3% yoy to reach USD25bn in FY18, increasing its share from 10% in overall exports in FY16 to ~20% in FY18E. This suggest that ex-digital, the IT exports grew by mere CAGR of 2% over FY16-18E.

This underperformance of non-digital/traditional services was on account of slowdown in global economy (mainly North America) and shift in budget allocations towards emerging technologies. Traditional business models have been disrupted by emergence of tech savy companies and as a result, the traditional service spends have been diverted towards digital in order to become agile enterprises.

Exhibit 1: Digital to drive overall IT-exports growth

Source: NASSCOM, Industry Reports, IIFL research Going forward, based on NASSCOM and industry estimates, and assuming the trend continues (NASCCOM said that digital is growing 1.5x faster than global digital growth rate), we expect digital to grow ~28% yoy in FY19E to reach USD32bn size and thus drive overall Indian IT exports growth of ~8% yoy in FY19E.

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Exports (Ex-Digital) Exports (Digital) Domestic Hardware

Diversion of budgetary spends towards newer technologies are driving overall IT growth

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Green shoots are visible

The performance of the Indian IT sector is heavily influenced by IT spends by the BFSI vertical (~50% of revenue) especially in the North America (~60% of revenues). As per Information Services Group (ISG) data, CY18 has started on a positive note with ~11% yoy growth in annual contract value (ACV) to USD12.2bn in Q4FY18. Traditional sourcing, however has declined by 6% yoy to USD6.3bn (on 14% yoy decline in BPO), while As-a-Service grew by impressive 40% yoy to USD5.9bn, in-line with trend of increasing spends towards digital.

Exhibit 2: Increasing Global ACV points at improving sentiment

Source: ISG, IIFL research

Amongst regions, Americas showed strength with combined ACV up 32% yoy to USD6.9bn. Both traditional sourcing and As-a-Service grew by impressive 31% yoy and 32% yoy respectively. As per ISG commentary, things are improving in American market as sourcing volumes reached an all-time high and easing pricing pressure aided 27% yoy increase in IT sourcing.

Exhibit 3: Traction in American ACV points at brighter outlook

Source: ISG, IIFL research

6.6 5.97.5 6.6

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Things are improving in American market as sourcing volumes reached an all-time high and pricing pressures are seen easing

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The outsourcing advisory firm added that on TTM basis, sourcing from financial services vertical (global) was up 20% yoy whereas, Healthcare, up 31% yoy, was the fastest growing vertical for sourcing on TTM basis. We believe that bottoming out of pricing pressure in US, and increasing TCV in US for Traditional services indicates a positive environment for Indian IT Services companies in the near future.

Industrialization of digital to aid IT majors

As per above trends and industry articles, digital deal sizes are already moving up from the initial stages. Accenture’s commentary and TCS signing its first USD50mn+ deal in digital in 3QFY18 provide evidence of growing deal sizes. We believe that as enterprises move from trial stage to full scale implementation stage, the flow of deals would move towards larger companies like TCS, Wipro and Infosys amongst others. All of the IT majors have indicated that they would be looking at ~30% of the revenue in the near future. Hence, we believe that Industrialization of digital would benefit larger companies.

IMS to be driven by Next-Gen Infrastructure Outsourcing

As per Dun & Bradstreet Research, the share of IMS (Infrastructure Management Services or IS outsourcing), in total IT services exports has increased from 17.8% in FY13 to about 24% in FY17. The growth has been at ~18% CAGR over the same period vs. ~9% of the overall industry (exports). This has been on account of robust growth in Infrastructure-as-a-Service on increasing preference for cloud technologies. Although this has caused deceleration in growth rates for traditional IMS on the said account, our interaction with company management suggests that the penetration of IS outsourcing is still low and as per industry reports, it is not at the levels of other services.

We expect challenges for data center revenues in IMS to continue and believe that end user computing (workplace services), network and security services still provide opportunities in the IMS space. This is because the focus is expected to shift to improving productivity and making organizations agile. In the near term, we expect growth rates to remain at 10-12%, higher than that of overall industry guidance of 7-9%. Our interaction with IT personnel suggests that although cloud migration is picking up, hybrid cloud (mix of on premises, private cloud and third party) is the most sensible option for the companies from business stand point. As per Forrester Research, companies with successful blend of data center and workplace services along with differentiating value proposition will position themselves to

All of the IT majors have indicated that they would be looking at ~30% of the revenue in the near future

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successfully deliver next-gen infrastructure outsourcing services. HCL Tech and Wipro are leaders as per the Forrester in terms of next-generation infrastructure outsourcing. HCL Tech scores higher on value proposition criterion. ER&D to outpace overall Industry growth

As per NASSCOM, at 16% of India’s IT-BPM market, Engineering Research & Development (ER&D) segment has been and continues to be the fastest growing segment. The segment has grown at 13% CAGR over 2011-16. ER&D services, comprising of product engineering services and process engineering services, pertains to high-end engineering services for improving a product or managing services.

As per LT Technology Services’ (LTTS) RHP, product engineering services address product development life cycle for companies, which produce discrete products through services in areas of mechanical engineering, embedded systems and software product engineering. Majority of the services outsourced today are product engineering services and there are very few third party India based ER&D services providers for process engineering services. Exhibit 4: Global ER&D industry service lines

Global ER&D Services Industry

Product Engineering

Mechanical/Electrical - External housing, Inner frame, Industrial Design, Styling, Surfacing, Ergonomics, Solid Modelling, Drafting, Structural analysis etc.

Embedded Systems - Embedded hardware & software, Semiconductor, Processor, RTOS, OS-ware, Codec, Communication protocol, Application software etc.

Software Engineering - Graphical user interface, mobile applications, application program interface, software product/platforms for ISV/Technology Companies

Process Engineering

Plant Engineering - Plant Design, Instrumentation and Control engineering, Civil/Structural engineering, Process and Instrumentation diagram (P&ID), FEED engineering

Manufacturing Engineering - Tooling and factory equipment design, Jigs & Fixture Design, PCB Manufacturing, Should Costing etc.

Source: Zinnov

ER&D segment has grown at 13% CAGR over 2011-16

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As per Zinnov (product engineering market research), the ER&D services is provided by a combination of in-house ER&D teams, global (offshore) in-house centers (GICs or Captives) and offshore third-party engineering service providers. R&D spends on product development by global top 500 R&D spenders across geographies stood at USD621bn in 2016. Companies part of this group include Amazon, Alphabet, Volkwagen, Roche, Samsung among others.

The total addressable size for captives and third-party engineering services outsourcing (3P-ESO) partners for product engineering stood at USD232bn of which USD85bn has been addressed so far. Lower penetration of outsourced work suggests that there is significant opportunity available for participants on the 3P-ESO side. The share of captives stands at USD34bn (40%) and that of 3P-ESO at USD51bn (60%). Going forward, overall growth in R&D spends will be driven by rising spends behind IoT and need for unique and customized products to adhere to changing trends. This, in-turn will drive the growth for outsourcing of ER&D services with software expected to be the fasted growing segment. The USD232bn addressable market is expected to grow to USD302bn by 2021E implying 5% CAGR over 2016-21E.

Exhibit 5: Total addressable size for captives and 3P-ESO vendors

Source: Zinnov

2016 2021

Mechanical 78 83

Embedded 93 107

Software 61 112

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India as Global ER&D hotspot to boost 3P-ESO revenues

Further to the Zinnov report, India is among the top destinations for offshore in-house R&D centres, with share of USD13.4bn of total USD34bn. Also, it is key market (third largest) in terms 3P-ESO with share of USD8.9bn of USD51bn. China is also key market in terms of offshore in-house R&D centers with ER&D spend share of USD10.2bn. This suggests that Asia is the preferred location for ER&D activity. Within India, in-house R&D centers are expected to post CAGR of 13.7% to reach USD22.4bn in 2020E from USD13.4bn in 2016 while 3P-ESO is expected to grow at 14.1% CAGR and reach USD15.1bn in 2020E from USD8.9bn in 2016.

Exhibit 6: Total addressable size for captives and 3P-ESO

Source: Zinnov

As per NASSCOM article, there is a trend of large corporates adopting in-sourcing and setting up R&D centers in India. Hence, the GICs are expected to play critical role in parent organization retaining its competitive edge and provide niche skills from earlier operations as cost arbitrage centers. As these GICs move up the value chain, they are expected to become customers to 3P-ESO partners and require integration of operations with GICs. This presents greater opportunity for 3P-ESO players.

HCL Tech is the largest company in ER&D space in terms of revenue while LTTS is the largest pure play ER&D services company in India. Cyient derives ~63% of its revenue from ER&D services.

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As GICs move up the value chain, they are expected to become customers to 3P-ESO partners and require integration of operations with GICs

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Exhibit 7: Prominent companies as per Zinnov Zones

Verticals Large Cap IT Mid Cap IT

Overall HCL Tech, Wipro, TCS LTTS, Cyient

Mechanical Engineering – (Overall)

TCS, Tech Mahindra, HCL Tech

Cyient, LTTS

Embedded Systems (Overall)

Wipro, HCL Tech, TCS LTTS, Mindtree

Software - Enterprise Wipro, TCS Persistent Systems, Mindtree

Software - Consumer HCL Tech, Infosys, Wipro Persistent Systems, Mindtree

Automotive TCS, Wipro, HCL Tech KPIT, LTTS

- Industrial HCL Tech, Tech Mahindra, TCS

LTTS

- Transport Tech Mahindra, HCL Tech, TCS

Cyient, LTTS

Semiconductor Wipro, HCL Tech, TCS L&T TS, Mindtree

Consumer Electronics HCL Tech, TCS, Wipro Tata Elxsi, LTTS, Mindtree

Telecom & Networking Wipro, HCL Tech, TCS LTTS, Mindtree

Source: Zinnov

We believe that IT firms which are capable of scaling up focus on newer technologies will better offset the pricing pressures seen in traditional services going forward. We prefer Infosys in the large cap IT space vs. TCS on account of unjustified discount to the latter. We also like HCL Tech on account of higher mix of IMS revenues and presence in the higher growth ER&D segment. We like Persistent because it is transitioning from an outsourced product development (OPD) company to investing and building offering around Data, Digital and IoT.

Exhibit 8: MF ownership of IT is below average level of 9.5%

Source: Ace MF

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Infosys Ltd

CMP: `1,188; 1-year Target: `1,379

Sector IT

Recommendation BUY

Upside 16.1%

Stock Data

Sensex 34,451

52 Week h/l (`) 1,221/860

Market cap (`Cr) 2,59,409

BSE code 500209

NSE code INFY

FV (`) 5.0

Div yield (%) 3.7

Shareholding Pattern

Sep-17 Dec-17 Mar-18

Promoters 12.8 12.9 12.9

DII+FII 72.9 73.4 74.2

Individuals 14.3 13.7 12.9

Source: www.bseindia.com

Share Price Trend


Infosys, India’s second largest IT company, would benefit from stable operating environment and reap benefits from its investments in digital capabilities. It trades at unjustified discount of ~23% to TCS despite growth deltas expected to converge between the two in FY20E on investments behind digital and efforts to boost deal wins. Attractive valuations and USD2bn to be returned to shareholders in FY19 provides attractive risk-reward. We build revenue and adj. PAT CAGR of 9.9% and 5.6% respectively over FY18-20E. We recommend BUY with target of `1,379 (18x FY20E EPS).

Stability returns: Infosys had lost ground to its peers because of disruption stemming from management/promoter issues. We believe that with right hire in place, the focus has now turned to execution. Mr. Parekh has credible record and can turn the focus on deal wins. Digital is ~25% of its portfolio and investments in building digital capabilities and sales team expansion are main revenue drivers Strategy refresh to boost revenues: Infosys has mapped out four areas of focus as part of its Navigating your next strategy which covers scaling up digital revenues, focusing on customers, reskilling of employees and increasing local presence. This is largely the reason behind 100bps lower guidance for FY19E but we believe that higher digital services component, having better gross margins and rupee tailwinds would aid margin recovery by FY20E. Sound business, discount to TCS: Despite having similar growth profile as TCS in FY18, Infosys’ discount to TCS reached ~23%. TCS would outperform in revenue growth terms vs. Infosys in FY19 on deal ramp ups, but we expect Infosys to catch up by FY20E, as its sales and investments behind digital and sales team expansion would result in deal wins. Moreover, strong cash generation would be paid out via special dividend and a potential buy-back. We believe that Infosys can grow successfully under new leadership and is a preferred pick in large cap IT space that would benefit from commercialization of digital theme. Financial Summary

Consolidated `cr FY17 FY18 FY19E FY20E

Revenue 68,484 70,522 76,884 85,237

Growth (%) yoy 9.7 3.0 9.0 10.9

EBIT% 24.7 24.3 23.5 23.8

Adj. PAT 14,353 15,011 15,071 16,731

Growth (%) yoy 6.4 4.6 0.4 11.0

P/E (x) 18.1 17.3 17.2 15.5

ROE % 22.0 22.4 23.0 24.2

ROIC % 58.5 56.8 49.0 53.1

Source: Company, IIFL Research

29300

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3230033300

34300

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860900940980

10201060110011401180

Apr-17 Aug-17 Dec-17 Apr-18

Infosys Ltd Sensex

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Infosys Ltd

Balance Sheet Snapshot

` Cr FY17 FY18 FY19E FY20E

Share Holders Funds 68,982 64,923 66,393 72,051

Total Liabilities -180 -420 -420 -420

Sources of Funds 68,802 64,503 65,973 71,631

Fixed Assets 12,492 12,390 12,750 13,036

Other Assets 22,987 20,581 20,581 20,581

Net Current Assets 33,323 31,532 32,641 38,014

Application of Funds 68,802 64,503 65,973 71,631

Source: Company, IIFL Research Company Background

Infosys is India’s second largest and a leading provider of consulting, technology, outsourcing and next generation services. Application development & maintenance (31.1% of revenue, as on Q4FY18) and Consulting, Package Implementation & Others (32%) are its main service lines. BFSI forms the largest vertical (33%) followed by Manufacturing (21.9%). North America (59.4%) and Europe (24.8%) are the largest contributors in terms of geography. It had 2,04,1017 employees as on Q3FY18. Exhibit 1: Revenue by service line as on Q4FY18


Application Development & Maintenance,

31.1%

Consulting, Package

Implementation & Others, 32.0%

Testing Services, 9.8%

IMS, 9.3%

BPM, 5.4%

PES, 4.0%

Products and Platforms, 5.3%

Others, 3.1%

Infosys is India’s second largest and a leading provider of consulting, technology, outsourcing and next generation services

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Infosys Ltd

Exhibit 2: Revenue by verticals – Q4FY18


Exhibit 3: N. America & Europe are largest contributors – Q4FY18


Exhibit 4: Employee count has increased to over 2 lakhs in FY18


Banking & financial services,

26.2%

Insurance, 6.8%

Manufacturing, 21.9%

Retail & CPG, 13.3%

Transport & Logistics, 2.5%

Life Sciences & Healthcare, 6.6%

Energy & Utilities, 5.9%

Communication and Services,

10.8%

Others, 6.0%

North America, 59.4%

Europe, 24.8%

India, 2.8% ROW, 13.0%

204,107

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Infosys Ltd

“Navigating your next” and focus on deal wins Infosys has mapped out four areas of focus as part of its “Navigating your next” strategy. This would entail (1) Scale up of digital, (2) energizing client’s core via automation and AI, (3) reskilling employ on technologies and (4) increased localization of talent. The management has indicated that it would invest in areas of digital where it feels it is underinvested and will be expanding its sales team, especially in Europe, to accelerate deal wins. The management is positive on the BFSI recovery in FY19 with regional banks and US and European financial institutions increasing their IT spends. We believe that Mr. Parikh would step up the focus and target higher deal wins. Although above steps would exert pressure on margins, we believe that higher gross margins of digital services would aid in margin defence. Digital capabilities to support growth

Digital contribution to Infosys’ overall top-line is at 25.5% as on FY18. Digital is expected to be the next growth driver for overall Indian IT exports as per NASSCOM. Infosys is already witnessing favorable demand for digital services and investments behind expanding its portfolio of next-gen offerings, which are aiding growth, while traditional services face pricing pressure. We also believe that as the deal sizes grow, clients would be more inclined to opt for larger services firms like Infosys for scaled rolled out.

Exhibit 5: Indian IT Services digital revenues need scale up

Source: Bloomberg, Company, IIFL Research

~ 55.0

25.5 25.0 + 23.8

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Digital Revenue (%)

Digital is expected to be the next growth driver for overall Indian IT exports as per NASSCOM

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Infosys Ltd

Strong balance sheet, steep discount

Infosys has huge cash reserves (~`20,000cr, FY18) and strong cash generation, which would ensure that the dividend payouts would continue despite 5% buy-back conducted in FY18. The management mentioned that apart from current policy of returning 70% of FCF, it has identified USD2bn to be paid to shareholders in FY19. This would be via special dividend of Rs10 amounting to USD400mn, while the rest would be decided at the later date. We believe that this will be likely via a buy-back route. Finally, we believe that with cloud of uncertainty now passing by and right hire in place, we expect the company to focus on execution and gain some lost ground. Infosys’ discount vs. TCS has widened in recent time, which we feel is unwarranted. Hence, we expect the gap to converge. Hence we value Infosys at 18x FY20E EPS on higher dividend payment and higher chances of buy-backs. Exhibit 6: Infosys discount to TCS should shrink going ahead


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Infosys Disc to TCS (3Yr)

Infosys Disc to TCS 3 Yr Average Disc

We believe that with cloud of uncertainty now passing by and right hire in place, we expect the company to focus on execution and gain some lost ground

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HCL Technologies Ltd

CMP: `1,088; 1-year Target: `1,309

Sector IT

Recommendation BUY

Upside 20.3%

Stock Data

Sensex 34,451

52 Week h/l (`) 1,108/796

Market cap (`Cr) 1,51,476

BSE code 532281

NSE code HCLTECH

FV (`) 2

Div yield (%) 2.3



Promoters 60.1 60.2 60.2

DII+FII 35.2 36.1 36.3



Share Price Trend


HCL Tech (HCLT), India’s fourth largest IT services company is poised to perform well on account of expected recovery in its main service line, IMS. It is the largest third party engineering services partner in India by revenues, which bodes well for the company. This is because, both these service lines are characterized as underpenetrated, which would enhance the overall growth rates. Its strategy to invest in IPs is another growth driver for the company. We expect HCLT to post revenue and PAT CAGR of 10.4% and 10.5% respectively over FY18-20E. We recommend BUY with target price of `1,309 (17x FY20E EPS).

Recovery in IMS to aid revenue growth: The organic growth for HCLT has paused in recent quarters due to sluggish state of IMS (Infrastructure Management Service). The service line has been in frozen state owing to slower decision making in US geography. The management is confident that things should look up and believes that overall penetration level is still low. The growth rates are expected to be better than overall industry, which bodes well for HCLT. Largest ER&D services outsourcing partner can help growth: HCLT, is the largest ER&D services outsourcing player in India. Owing to India’s positioning of place to set up R&D center, scope of work carried out by captives is expected to increase, which in turn should benefit off-shore outsourcing partners like HCLT. HCL figures in most of Zinnov’s zones, which speaks volumes about its offerings and scalability. We believe that this horizontal can become the next IMS like growth driver for the company. IP partnerships a step in right direction: HCLT has been active in signing IP deals with total investments of ~USD1.2bn till date. This is expected to stabilise revenue and margin profile of the company as the revenue stream is sticky in nature and better than company level margins. HCLT has a wide user base for these products and can be easily cross sell, thus enhancing the revenues.

Financial Summary Consolidated `cr. FY17 FY18E FY19E FY20E

Revenue 46,723 50,758 56,815 61,894

Growth (%) yoy 14.2 8.6 11.9 8.9

EBIT% 20.3 19.9 20.2 20.4

PAT 8,456 8,779 9,773 10,723

Growth (%) yoy 15.0 3.8 11.3 9.7

P/E (x) 17.9 17.3 15.5 14.1

ROE % 28.0 25.4 25.3 24.4

ROIC % 70.1 57.9 58.2 61.7 Source: Company, IIFL Research

2930030300313003230033300343003530036300

800840880920960

100010401080


HCL Technologies Ltd.

Sensex

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` Cr FY17 FY18E FY19E FY20E


Total Liabilities 1,082 1,082 1,082 1,082

Sources of Funds 34,032 37,201 42,276 47,845

Fixed Assets 9,154 11,761 12,106 12,327

Other Assets 22,987 20,581 20,581 20,581

Net Current Assets 1,891 4,859 9,590 14,937



Company Background

HCL Technologies (HCL) is a leading global IT services company. HCL focuses on providing an integrated portfolio of services underlined by its Mode 1–2–3 growth strategy. Mode 1 encompasses the core services in the areas of Applications, Infrastructure, BPO and Engineering & R&D services, leveraging DRYiCETM Autonomics to transform clients' business and IT landscape, making them 'lean' and 'agile'. Mode 2 focuses on experience–centric and outcome–oriented integrated offerings of Digital & Analytics, IoT WoRKS™, Cloud Native Services and Cybersecurity & GRC services to drive business outcomes and enable enterprise digitalization. Mode 3 strategy is ecosystem–driven, creating innovative IP–partnerships to build products and platforms business.

Exhibit 1: IS and ER&D form ~60% of revenues (LTM Mix)


Application Services,

36.1%

Infrastructure Services, 38.1%

Business Services, 3.7%

Engineering and R&D Services,

22.1%

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Exhibit 2: Revenue by verticals (LTM Mix)


Exhibit 3: Americas accounts for bulk of the revenue (LTM Mix)


Favorable growth metrics v/s peers

HCL Technology’s growth has largely been fueled by its strategy to capitalize on the higher growth in the IMS service line. On adjusted financial year basis, its IMS division grew at revenue CAGR of 23.2% over FY12-17. While the overall USD revenues for the company grew at CAGR of 11.6%. At the same time the contribution of IMS surged from ~24% in FY12 to 40% in FY17, suggesting that the growth was largely driven by IMS. However, ER&D revenue contribution remained constant during the same period but grew at CAGR of 11.8% during the same period.

Financial Services,

24.7%

Manufacturing, 35.4%

Lifesciences & Healthcare,

11.7%

Public Services, 10.9%

Retail & CPG, 9.4%

Telecommunications, Media, Publishing &

Entertainment, 7.9%

Others, 0.1%

Americas, 62.8%

Europe, 28.2%

RoW, 8.9%

HCL’s IMS division grew at revenue CAGR of 23.2% over FY12-17

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Exhibit 4: IMS drove majority of growth in the past


Although, IMS growth has been erratic and on a slowing trajectory in the past few years, it still is the main growth driver for the company. The growth has been impacted owing to shift towards cloud, which has impacted the data center revenues. We believe that, as Infrastructure, as a Service continues to grow, the focus of businesses will movetowards work place services (end user computing, to improve productivity levels). We project the service revenues for the company to grow at CAGR of 10.5% over FY18E-20E on the back of improving decision making in US and owing to its strong position in Next-Gen Infrastructure Outsourcing space.

HCL Tech is the largest listed ER&D service company in India by revenue and figures in most of the Zinnov’s zones for Product Engineering services. This augurs well for the company as ER&D service, the next fastest growing horizontal would benefit from the favorable environment for the ER&D space. We expect ER&D services to post revenue CAGR of 11.2% over FY18E-20E owing to its strong capabilities in ER&D services.

Exhibit 5: India is the largest listed ER&D service provider


-20

0

20

40

60

FY13 FY14 FY15 FY16 FY17

Application Services (%) Infrastructure Services (%)

Business Services (%) Engineering and R&D Services(%)

388

861

1,303

484

-

200

400

600

800

1,000

1,200

1,400

Infosys Wipro TCS HCL Tech Cyient LTTS Tata Elxsi

USD

Mn

We expect ER&D services to post revenue CAGR of 11.2% over FY18E-20E owing to its strong capabilities in ER&D services

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IP partnerships are a step in the right direction

HCL Tech had invested US$310mn in its IP partnership portfolio, thereby taking its overall IP investment to date to US$1.15bn. The growth in the ER&D services (IP partnership revenues are reported here) can be attributed to synergies from its IP-partnerships to some extent. HCL Tech acquires IPs from leading companies like IBM. These licensing agreements depend on the expected life of the IP. HCL, builds upon the existing IP using its product engineering capabilities to somewhat extend the life of the IP. These present an excellent cross selling opportunity for HCLT, which has a diverse client base. The management has suggested that there is thorough evaluation with respect to technology risk and are fairly confident of the strategy citing sticky revenue stream and higher than company level margins.

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Persistent Systems

CMP: `747 1-year Target: `966

Sector IT

Recommendation BUY

Upside 29.3%

Stock Data

Sensex 34,451

52 Week h/l (`) 878 / 561

Market cap (`Cr) 5,974

BSE code 533179

NSE code PERSISTENT

FV (`) 10

Div yield (%) 1.2



Promoters 30.7 30.6 30.5

DII+FII 37.4 38.5 40.6



Share Price Trend


We believe that the recent correction in Persistent Systems’ stock price provides an excellent entry point to capture the expected improvement in overall performance. Persistent’s digital business (~22% of revenue) is expected to drive the growth for the company, while it transitions from offshore product development to partnerships (IBM alliance) and IP-led offerings (Accelerite). We expect Persistent to post revenue and PAT CAGR of 13.4% and 19.5% over FY18-20E, respectively. We recommend BUY with target price of `966 (17x FY20E EPS). Favorable change in business mix: Persistent’s ISV business accounted for ~60% of the business in FY14. It recognized the trend of spends moving from ISV to digital and Enterprise early and has focused on digital and IoT segments. Its non ISV business has grown substantially and as a result the contribution of ISV business has declined to 38.5% in Q3FY18 and non-ISV business have managed to build significant base. Persistent stands to benefit from favorable business mix with large chunk of revenue growing at a faster clip. Digital to drive revenue growth: Digital accounts for 22% of overall revenue and is its main growth driver. It is focusing on platform based solution for financial services and healthcare verticals, as the clients are undergoing transformation. Its platform based partnership, which account for ~75% of digital revenues has mainly aided growth. We believe that higher focus on select verticals and its partnership-led

strategy should drive digital revenue CAGR of 31.5%. IoT businesses to recover in FY19E: The stock has corrected by ~11% after the company issued profit warning for Q4FY18E owing to decline in IP revenues. However, the company is expected to recover its lost revenue over the next few quarters, which should assist its overall growth rates. Margins are expected to decline, however, the company has completed a major co-development phase with IBM (for IoT) which would aid margins going forward.

Financial Summary

Consolidated `cr FY17 FY18E FY19E FY20E

Revenue 2,878 3,026 3,455 3,891

Growth (%) yoy 24.5 5.1 14.2 12.6

EBIT% 11.0 10.5 11.5 12.4

PAT 301 318 383 455

Growth (%) yoy 1.4 5.6 20.4 18.5

P/E (x) 17.9 16.9 14.0 11.8

ROE % 17.0 15.9 17.3 18.2

ROCE % 27.3 20.2 20.0 22.2


29300

30300

31300

32300

33300

34300

35300

36300

550590630670710750790830870


Persistent Systems Ltd

Sensex

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Persistent Systems


` Cr FY17 FY18E FY19E FY20E


Total Liabilities 15 14 14 13

Sources of Funds 1,914 2,107 2,356 2,665

Fixed Assets 552 567 561 550

Other Assets 727 727 728 727

Net Current Assets 635 813 1,068 1,389



Company Background

Persistent is a leading offshore product development player that helps build software products with services across all phases of the product lifecycle. Its services span around design, development, and maintenance and enhance the functionality of the software products. The company caters to Infrastructure and Systems, Telecom and Wireless, Life science, Healthcare, and Financial Services. The company’s business strategy can be classified as (1) Services – software and product development services for customers, (2) Alliance – traditional product engineering services and IP-led product development with IBM, (3) Digital – Enabling digital transformation for enterprises (trusted partner of Platforms like Appian and Salesforce) and (4) Accelerite – develops products (IP based, builds on existing IP). Geographically, North America accounted for 84.4% of its revenue as on Q3FY18. Exhibit 1: Revenue by business line – Q3FY18


Services, 41.9%

Digital, 22.0%

Alliance, 29.6%

Accelerite, 6.5%

North America accounted for 84.4% of its revenue as on Q3FY18

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Persistent Systems

Exhibit 2: Non-ISV business to drive growth with favorable base


Digital the main growth driver

Persistent is focused on Healthcare and Financial Services in Enterprise digital transformation and has sizable new contracts. The company is forging partnerships with institutions in health space via joint development of IPs. Joint development with Partners Healthcare and United Services Automobile Association, although in initial stages, can be meaningful contributors in the long run. Major portion of digital revenues includes platform based partnerships with the likes of Salesforce, Appian, and Oracle. This has been the main reason for digital posting ~50% yoy growth in FY17, although on a lower base. Overall, we see Digital revenues growing at 31.5% CAGR over FY17-20E. Exhibit 3: Digital revenue CAGR est. at 31.5% over FY17-20E

Source: Company, IIFL Research Profit warning on IP revenue decline – near term roadblock

Days before the end of fiscal year, Persistent gave out a profit warning by informing that it is expecting a decline in IP revenues for Q4FY18. This would impact the revenue and EBITDA margin for Q4FY18 and FY18. The sequential drop in IP revenue is expected to be

ISV, 38.5%

Enterprise, 34.7%

IP ‐ Led, 26.8%

195 207 218 230

70 98 128160126

132140

15038

3237

44

-

100

200

300

400

500

600

700

FY17 FY18E FY19E FY20E

USD

Mn

Services Digital Alliance Accelerite

Major portion of digital revenues includes platform based partnerships with the likes of Salesforce, Appian, and Oracle

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Persistent Systems

about USD8mn (~`52cr) for Q4FY18. Alliance business (IBM), accounting for ~30% of overall revenue is made up of services contributing~45% to alliance business and IP led product development accounting for the balance (IP-IoT – 37% and IP-ex IoT – 18%). Although the drop was expected, as Q3 is a seasonally strong quarter, we believe that the decline in revenue is more to do with Accelerite business. However, we believe that the company will be able to recover the lost revenue in FY19E and expect the margins to improve going forward as the margins are on the higher side (gross margins are generally above 50-60% for IP). We build Alliance and Accelerite revenue CAGR of 5.8% and 5.2% respectively.

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Disclaimer

Recommendation Parameters for Fundamental/Technical Reports: Buy – Absolute return of over +10% Accumulate – Absolute return between 0% to +10% Reduce – Absolute return between 0% to -10% Sell – Absolute return below -10% Please refer to http://www.indiainfoline.com/research/disclaimer for recommendation parameter, analyst disclaimer and other disclosures. India Infoline Limited (Formerly “India Infoline Distribution Company Limited”), CIN No.: U99999MH1996PLC132983, Corporate Office – IIFL Centre, Kamala City, Senapati Bapat Marg, Lower Parel, Mumbai – 400013 Tel: (91-22) 4249 9000 .Fax: (91-22) 40609049, Regd. Office – IIFL House, Sun Infotech Park, Road No. 16V, Plot No. B-23, MIDC, Thane Industrial Area, Wagle Estate, Thane – 400604 Tel: (91-22) 25806650. Fax: (91-22) 25806654 E-mail: [email protected] Website: www.indiainfoline.com, Refer www.indiainfoline.com for detail of Associates. Stock Broker SEBI Regn.: INZ000164132, PMS SEBI Regn. No. INP000002213, IA SEBI Regn. No. INA000000623, SEBI RA Regn.:- INH000000248 For Research related queries, write at [email protected] For Sales and Account related information, write to customer care: [email protected] or call on 91-22 4007 1000

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