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Indian IT Services - PL INDIA IT Services Global IT stocks Leap ahead; Time to Reboot for Indian IT...
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March 09, 2017
Prabhudas Lilladher Pvt. Ltd. and/or its associates (the 'Firm') does and/or seeks to do business with companies covered in its research reports. As a result investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of the report. Investors should consider this report as only a single factor in making their investment decision.
Please refer to important disclosures and disclaimers at the end of the report
Indian IT Services
Global IT stocks Leap ahead; Time to Reboot for Indian IT
Sector Update Madhu Babu
[email protected] +91‐22‐66322300
Rating and Target price
Rating TP
Infosys BUY 1230
TCS Accumulate 2600
Wipro Reduce 500
HCL Tech BUY 990
Source: PL Research
Three year stock return of Global IT Stocks
58%
47%
43%
48%
40%
45%
50%
55%
60%
Atos
Accenture
CGI G
roup
Capgemini
Source: PL Research
Three year stock return of Indian IT stocks
9% 8%
‐18%
8%
‐20%‐15%‐10%‐5%0%5%
10%15%
TCS
Infosys
Wipro
HCL Tech
Source: PL Research
Indian IT services stocks have stagnated with tepid absolute returns over the past
three years, while global IT services stocks are on a roll. While Global IT services
vendors have delivered stable EBIT margin with a steady upward bias, Indian IT
vendors struggled to defend the forte on the margins. Acquisition strategy of
Global IT vendors has been tactical which included driving growth in Digital/ Cyber
Security, expanding geographic footprint and gaining scale. However, lacklustre
acquisition strategy has led Indian IT vendors fall behind the curve. We believe that
defending the margins could remain tough for Tier 1 IT vendors over FY18‐FY20E.
We believe that a good capital allocation could help companies in this phase of
transition. Our view is that Tier 1 vendors should have a consistent and steady
buyback plan. We believe that cash rich Tier 1 IT vendors should aim to trim their
sharecount by 10‐12% over a three‐four year period which could help boost the
earnings and drive re‐rating. Infosys and HCL Tech are our preferred large cap
picks. Hexaware and Persistent Systems are our midcaps. In this theme report we
analyse the impact of convergence in the IT services space.
Growth moderation at Indian IT: Accenture’s local currency revenue growth
guidance for FY17E is at 5‐8% local currency revenue growth which is almost
similar to revenue growth of Indian Tier 1 Vendors (TCS/Infosys set to report ~8‐
8.5% CC revenue growth for FY17E). This despite Accenture’s annual revenues at
~US$33bn almost twice the scale of TCS. We believe Indian IT sector is poised
for 7‐9% constant currency growth over FY18‐FY20E. With growth differential of
Indian IT narrowing v/s global peers ( Accenture), Indian IT stocks have seen a
reduction of growth premium in their P/E multiples. Hence, TCS/Infosys
currently trades at 15/25% discount to Accenture.
Acquisition strategy aided Global IT: Accenture’s growth outperformance is
being driven by robust traction in Digital, Cloud and Cyber Security which
accounts for 40% of Accenture revenues for FY16. Accenture spent over
US$2.4bn over three‐year period for ~50 acquisitions to boost Digital, Cyber
Security capabilities. Atos has scaled up over the past five years through strong
M&A strategy. Most recently, HP and CSC are merging the IT services business,
to transform into a much larger play. When compared to these, Indian IT
vendor’s acquisition strategies have remained tepid and company specific. Top
four companies (TCS/Infy/Wipro/HCL Tech) together spent USD2.6bn over FY14‐
9MFY17 for acquisitions. Indian IT vendors could have desisted from acquisition
in Digital owing to fear of margin dilution as well as cultural challenges in
integration. However, with Enterprise IT spend seeing a shift towards Digital; we
believe that a stronger consulting capability could remain key.
Margin differential narrowing: On a low base (8‐16% EBIT margin), global IT
services vendors have been showing gradual margin expansion. However Tier 1
Indian IT vendors (EBIT margin of 20‐26%) are struggling to defend margins.
While we expect global IT services companies to improve margins over FY18‐
FY20E, we see scope for margin challenges for Tier 1 IT. We believe that
Management and Investors are yet to realign expectations for a possible margin
correction over FY18‐FY20E.
March 09, 2017 2
Indian IT Services
Global IT services stocks hit Bulls eye, while Indian IT remain wayward
Exhibit 1: Stock price returns of Global and Indian IT companies
Company Brief Description Absolute stock price return in
three years
Absolute one year Stock price Return
Atos French IT services Major 58% 64%
Accenture Global IT services Major 47% 20%
CGI Group Canada Based IT Service Major 43% 9%
IBM Global IT major ( Services +Products) ‐4% 30%
CSC Global IT major based in USA 115% 125%
Capgemini French IT services Major 48% 9.2%
HP Enterprises Carved out separately one year ago NA 50%
EPAM Systems Belarus based IT vendor 100% 3%
TCS Indian IT major 9% 5%
Infosys Indian IT major 8% ‐12%
Wipro Indian IT major ‐18% ‐8%
HCL Tech Indian IT major 8% 2%
Source: Company Data
Over the last three years, TCS/Infosys/HCL Tech generated 9/8/8% absolute stock
price returns respectively, while Wipro declined by 18% on an absolute basis. In
sharp contrast, Global IT vendors delivered much better
returns. Accenture/Atos/CGI group/Capgemini delivered 47/ 58/43/48% return over
a three‐year period. Even, considering a one‐year stock return, major Global IT
services stocks trumped the Indian IT stocks by a wide margin. Our inference is that
FII’s would have suffered a huge opportunity cost by investing in Indian IT (v/s Global
IT) .What has led to this wide divergence?
We measure three factors which led to higher returns of Global IT vendors as compared to their Indian IT counterparts.
Margin Expansion by Global IT vendors v/s Stable to downward bias of Indian IT
vendors (despite Rupee depreciation)
Solid M&A strategy by Global IT vendors v/s lacklustre acquisition strategy by
Indian IT
Aggressive Dividend and Buyback policy of Global IT vendors
In this report, we analyze each of these factors in detail. Global vendors discussed in
this report include Accenture, Atos, Capgemini, HP Enterprises and CGI group.
March 09, 2017 3
Indian IT Services
Margin Trajectory: Global IT v/s Indian IT vendors
Global IT services vendors have been showing a steady margin improvement,
albeit on a low base. For example, HP enterprise EBIT margin came at 10.7% for
Q4FY16 v/s 5.1% in Q1FY16 (October year ending). Steady margin expansion has
helped in stock generating solid returns (up 50% in past one year). However, HP
Enterprises has showed some moderation in margin performance in recently
announced 1QFY17 results. Atos EBIT margin came at 9.4% for CY16 v/s 6.5%
in CY12. Margin improvement has aided in higher earnings growth for the
Global IT companies over CY13‐CY16. Most importantly, select companies within
global IT continue to guide for further margin expansion in CY17E/CY18E.
Exhibit 2: EBIT margin of Global IT vendors
EBIT Margin (%) CY13 CY14 CY15 CY16
IBM (Services Margin) 17.4 16.5 17.2 NA
Accenture* 15.2 14.3 14.5 14.6
HP Enterprises* 2.9 3.6 5.3 7.7
Capgemini 8.5 9.2 10.6 11.5
Atos 7.5 7.8 8.3 9.4
CGI Group * 10.7 12.9 14.2 14.6
Source: Company Data, PL Research *Note: Accenture has August 31st as year ending , HP Enterprises has October 31 st as year ending, CGI group has September year ending
On the contrary, Indian IT vendors are struggling to defend their already high
EBIT margins. The margin trajectory for Indian IT companies remains tepid
despite tailwinds from INR depreciation over the past six consecutive years.
Over FY14‐FY17E, Infosys EBIT margins remained relatively stable, while the
other three Tier 1 IT vendors showed erosion.
Exhibit 3: EBIT Margins of Indian IT Vendors v/s Average Exchange rate
FY11 FY12 FY13 FY14 FY15 FY16 FY17E
Average Rate (USD v/s INR) 45.5 48.1 54.5 60.7 61.2 65.6 67.1
EBIT margin (%)
Infosys 29.5 29.0 25.8 24.5 25.9 25.0 24.7
TCS 28.0 27.6 26.9 29.1 26.9 26.5 25.8
Wipro (IT services EBIT margin) 22.7 20.8 20.7 22.6 22.2 20.5 18.0
HCL Tech 14.0 16.3 20.1 24.1 22.2 20.4 20.3
Cognizant (Non GAAP) 20.3 20.2 20.6 20.2 19.7 19.5 NA
Source: Company Data, PL Research, * Cognizant is a CY ending company
Despite steep Rupee depreciation, Indian IT
vendors struggled to defend their EBIT
margins. However, Global vendors have
been showing steady EBIT margin
expansion albeit on a lower base
March 09, 2017 4
Indian IT Services
What’s aiding margin expansion at Global IT vendors?
Global IT vendors have focused on driving more work offshore as well as cost
rationalization. They have also focused on other restructuring initiatives which
include pruning high cost resource base, facility consolidation and mix shift in
business. We present the percentage of headcount in global delivery centres of
Accenture and Capgemini over the past few years.
Exhibit 4: Accenture’s % of headcount located in Global Delivery
41.6%45.8%
59.6%
66.2%71.7%
75%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
FY15
FY16
1QFY17
Source: Company Data, PL Research
Exhibit 5: Capgemini’s % of headcount located in Global Delivery
32.7%35.8%
38.7%41.6%
50.7%
56%
25.0%
30.0%
35.0%
40.0%
45.0%
50.0%
55.0%
60.0%
CY11
CY12
CY13
CY14
CY15
CY16
Source: Company Data, PL Research
Accenture has almost reached the effort mix which is similar to Indian IT vendors.
Accenture currently has 75% of its headcount in Global Delivery locations
(predominantly India and Philippines). Accenture has 295,381 employees in Global
Delivery centres. This is more than the absolute headcount of most of the Indian IT
vendors.
Exhibit 6: Accenture Total Headcount and Net additions
3QFY14 4QFY14 1QFY15 2QFY15 3QFY15 4QFY15 1QFY16 2QFY16 3QFY16 4QFY16 1QFY17
Total Headcount 293,529 305,882 318,700 323,278 336,092 358,458 372,507 372,579 375,490 383,735 394,083
Net addition 4,689 12,353 12,818 4,578 12,814 22,366 14,049 72 2,911 8,245 10,348
Global Delivery Headcount 194,502 205,235 218,188 225,878 237,149 256,846 270,271 272,745 276,363 285,240 295,381
GDM as a % of Total Headcount 66.3% 67.1% 68.5% 69.9% 70.6% 71.7% 72.6% 73.2% 73.6% 74.3% 75.0%
Source: Company Data, PL Research, Accenture has August 31 st as year ending
March 09, 2017 5
Indian IT Services
Capgemini has also been substantially boosting its base in India over the past few
years. I‐Gate acquisition has acted as a catalyst for further ramping‐up headcount in
India. As on CY16, Capgemini has a total headcount of 190,000 employees, of which,
56% are in Global delivery locations (vs. 13% as on CY06).
Capgemini also focused on hiring younger graduates and correcting the pyramid
structure. Capgemini’s guided that during CY15; ~42% of its gross additions were
young graduates.
“We have today more than 3,900 automation experts worldwide and we have done
automation work for more than 200 customer’s year‐to‐date. For example,
automating the monitoring of part of SAP managed service for a big client, we have
achieved 80% productivity improvement and we believe this part is scalable across
our entire SAP managed service landscape. We’re also leveraging our global
production centre, representing now 55% of our workforce to accelerate our growth
in Europe, with higher offshore adoption in France and the Netherlands. Our large
Indian platform is instrumental to our competitiveness.”
“Strong growth in offshore service in Nordic and Germany and we now think there is
more openness and appetite for equivalent service in Benelux and France. To the
example of the large deals signed which now starting to production. And for the first
time in France offshore leverage is exceeding 30%”. Extracts from Capgemini Concall
Transcripts on key levers which are driving margins
“Operating profit (for Enterprise services business) improved 250 basis points year
over year, to 10.7% in Q4FY16, the highest since Q4’09, team continues to execute on
productivity improvements in delivery and sales. For the full year, we delivered
operating margins of 7.7%, well above our original guidance of 6‐7%. We continue to
track against our longer‐term goal of 60% headcount in low cost locations and
completed the quarter with 51% of our headcount in low cost locations” extracts
from HP Enterprises Q4FY16 concall
Our inference is that similar strategies (operational efficiencies, pruning low margin
deals, automation, higher offshoring, restructuring high cost resources and facility
consolidation) have aided margin expansion for global IT services companies. Our
view is that margin expansion could continue over next two years for global IT
service companies. This would be driven by pruning high cost resource base, higher
market share in Digital, Cloud, Cyber security, improving efficiency in execution and
higher offshoring.
HP Enterprises has seen a strong
improvement in margin trajectory in CY16
which aided in solid stock price returns.
Post its merger with CSC, the combined
entity continues to aim at further margin
expansion
March 09, 2017 6
Indian IT Services
Indian IT vendors facing multiple margin headwinds
Select Indian IT vendors (TCS/Infosys) operate at 2x the EBIT margin profile of global
IT vendors. Over the past few years, Indian IT vendors had increased onsite
Investments, expanded onsite delivery centres, and took over onsite headcount as
part of deals. Apart from this, IT companies (Wipro,Tech M, Mindtree) have also
acquired onsite centric companies. These factors, coupled with other operational
headwinds (pricing pressure, subcontracting expenses), led to Indian IT vendors
struggle on margin front despite steep currency tailwinds ( INR depreciated by over
45% vs USD in a span of six years). Key headwinds for margins for Indian IT vendors
include:
Pricing pressure in traditional services (which accounts for 50‐60% of total
revenues)
Taking over deals which involve rebadging of onsite employees (HCL Tech
margins suffered led by deals which had onsite rebadging).
Onsite centric acquisitions (Tech M /Mindtree’s margins tumbled led by onsite
acquisitions)
Constrains on visas leading to increasing subcontracting costs.
We elaborate few of these margin headwinds in detail.
Pricing Pressure hurting traditional IT services
Offshore pricing is under tremendous pressure which is leading to revenue leakage.
Infosys/Mindtree are the only vendors which report realisations separately
(Onsite/Offshore realisations). As on Q3FY17, Infosys offshore realisations stood at
US$22.2 per hour (v/s US$25.6per hour in Q1FY15). This represents a 14% drop in
offshore pricing in a period of 11 quarters. This clearly indicates the quantum of
pressure in offshore revenues led by pricing pressure. Over the same period, delivery
costs continued to increase owing to regular salary hikes and wage inflation. Even on
a constant currency Index pricing, Infosys offshore realisation is down 7.7% as on
Q3FY17 (v/s Q1FY15 offshore realisation). Mindtree’s offshore realisation stood at
US$17 per hour as on Q3FY17 (v/s US$19.8 per hour as on Q1FY15). This represents
a 15% drop in offshore realisation over 11 quarters. Hence, offshore volume growth
has not translated to commensurate revenue growth.
Infosys offshore pricing as on Q3FY17 has
dropped by 8% compared to Q1FY15.
Hence, offshore volume growth has not
been able to translate to commensurate
revenue growth
March 09, 2017 7
Indian IT Services
Exhibit 7: Infosys Offshore realisation per employee per month
4516 4317
4047
4024
3948 3906
3600
3800
4000
4200
4400
4600
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
(US$)
Source: Company Data, PL Research
Exhibit 8: Mindtree Offshore realisation per employee per month
3498
3528
32893264
2993
3007
2600
2800
3000
3200
3400
3600
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
(US$)
Source: Company Data, PL Research
Exhibit 9: Infosys realisation per employee in CC ( QoQ)
‐0.6%
0.4%
‐2.4%‐2.0%
‐2.3%
3.2%
‐2.4%
‐0.8%‐1.4%
0.2%0.3%
‐3.0%
‐2.0%
‐1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
Source: Company Data, PL Research
Exhibit 10: Mindtree realisation per employee in USD (QoQ)
‐0.5%
‐1.5%
2.4%
‐3.9%‐3.0%
‐1.4%
0.6%
‐4.0%‐4.5%
0.5%
‐0.1%
‐5.0%
‐4.0%
‐3.0%
‐2.0%
‐1.0%
0.0%
1.0%
2.0%
3.0%
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
Source: Company Data, PL Research
Uptick in subcontracting expenses also weighed on margins
Owing to limited H1B visas and high demand, Indian IT vendors have faced a
shortage of visas and hence had to rely on onsite subcontractors. This has also been
a margin headwind for Indian IT over FY13‐FY16.
Subcontractors are usually more expensive compared to employees sent on H1B
visas. Indian IT vendors might hire subcontractors directly or through agencies
and staffing companies which present additional costs. Subcontractors also
charge on an hourly basis and costs of subcontractors are 15‐20% more
expensive. For Infosys, Subcontracting expenses as a percentage of sales stood
at 6.8% for FY16 (v/s 3.7% as on FY12).
March 09, 2017 8
Indian IT Services
Exhibit 11: Infosys v/s TCS subcontracting costs (as a % of sales)
5.1% 5.3%
3.8%
5.5%
6.3%
7.5%
6.4%6.6%
6.2% 6.4% 6.6%7.2% 7.2%
7.7% 7.8%7.5%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
Q1FY14
Q2FY14
Q3FY14
Q4FY14
Q1FY15
Q2FY15
Q3FY15
Q4FY15
Q1FY16
Q2FY16
Q3FY16
4QFY16
1QFY17
2QFY17
3QFY17
Infosys TCS
Source: Company Data, PL Research
Deals involving Re‐badging of Onsite Employees: Indian IT vendors took over
deals which involved re‐badging onsite employees. This has also been a major
margin headwind for select vendors. With an aim to expand service footprint,
vendors focused on onsite acquisitions. While this has boosted competencies, it
weighed on margin trajectory. Midsized IT vendors like Mindtree suffered as its
margins tumbled post onsite acquisitions (Bluefin and Magnet).
Despite a 44% drop in INR v/s USD over the past six years, Indian IT vendors
EBIDTA margins remained static with a downward bias. We believe margin
challenges are likely to remain over FY18‐FY20E predominantly led by scope for
increased onsite intensity in the business.
Margin headwinds remain an overhang for Indian IT over FY18‐FY20E
Much of the noise in the sector over the past four months has been the possible
restrain on H1B visas on Indian IT companies. We analyze the same in detail.
While there are limited H1B visas (65,000 per year+ additional 20,000 visas for
Masters Degree), the demand has far outstripped supply. This leads the USCIS to
rely on random lottery system for visa allocation. For FY17, USCIS received over
236,000 applications for H1B visas (v/s 65,000 available visas).
March 09, 2017 9
Indian IT Services
Exhibit 12: Number of days taken to reach Visa cap limit
301
236
72
5 5 50
50
100
150
200
250
300
350
FY12
FY13
FY14
FY15
FY16
FY17
Number of days taken to reach Cap
Source: Company Data, PL Research
High demand for H1B visas led to the cap being reached within the first week of
opening of the H1B window (April 1 st of every year). Indian IT vendors have been
one of the major users of H1B visas over the past several years. We present the data
of new H1B visas given in 2015 for various corporations. For FY16, Indians got ~70%
of the total H1B visas issued by North America. TCS, Cognizant, Accenture Wipro,
Infosys were the top five users of new H1B visas in 2015.
March 09, 2017 10
Indian IT Services
Exhibit 13: New H1B Visa issued in 2015 for different corporations
New H1B visas issued in 2015
TCS 4,674
Cognizant 3,812
Accenture 3,385
Wipro 3,079
Infosys 2,830
IBM 1,919
Tech Mahindra 1,576
HCL America 1,339
Deloitte 1,203
Amazon 1,058
Syntel 1,050
Microsoft 961
Google 833
Ernst & Young 663
Larsen & Toubro Infotech 649
PricewaterhouseCoopers 647
Intel 628
Capgemini 548
Apple 532
I Gate 532
Oracle 493
Mindtree 464
Facebook 408
JPMorgan Chase 295
UST Global 287
Mphasis 274
Cisco 267
Yahoo! 251
Goldman Sachs 243
NTT Data 220
Source: Company Data, PL Research, U.S. Citizenship and Immigration Services; National Foundation for American Policy.
A part for new H1B visas, companies also file for extension of H1B visas (The
H1B visa is issued for three years and gets an additional three year extension).
Cost of H1B visa has increased over the years: The cost of H1B visa has steadily
increased over the years owing to various additional levies by the US
government. We note that cost of H1B visa is now at ~US$6325 to US$8000 per
person for a new initiation for most of the Indian IT companies. The break‐up of
the H1B visa cost is shown below.
March 09, 2017 11
Indian IT Services
Exhibit 14: Various costs included for H1B Visa
Fee type Fee in USD Details
Base filing fee $325 For every petition
AICWA Fee (American Competitiveness and Workforce Improvement Act of 1998)
$750 or $1,500 $750 – for employers with 1 to 25 full time employees. $1500 – for employers with 26 or more full time equivalent employee )
Fraud prevent & detection fee $500 Only applies to New H1Bs and Change of employer’s petitions only. Does not apply to Chile and Singapore based H1B1 petitions
Fee based on Public Law 114‐113 $4,000 Applicable, if 50 or more employees and more than 50% of employees are on H1B or L1 Visa status, required for new H1B filing and change of employers.
Premium processing fee (Optional) $1,225 For faster adjudication within 15 calendar days. As per this year’s press release, USCIS will consider the 15 day clock from starting from no later than May 16th.
Immigration Attorney Fee Varies from $500 to $3000
This varies depending on the attorney. This fee applies to companies that work with third party immigration attorneys for filing the H1B Visa petitions. Some large organizations have in‐house attorneys. If the employer does not have any in‐house attorney, it would cost them anywhere from $500 to $3000.
Source: Company Data, PL Research
There is a scope for Trump administration to further increase H1B visa fees for
H1B dependent companies. This could be an additional cost headwind for the
sector.
H1B visas are crucial for Indian IT companies as a part of the business model.
Infosys has 14,659 employees on H1B visas and 1364 employees in L1 visa (Data
from Infosys annual report) as on FY16.
Onsite effort for IT services is ~20‐25% for Indian IT vendors (rest is offshore).
Onsite effort per project can vary based on the service line of the project, client
requirements etc. Any restrictions on issuing fresh H1B visas or renewals of
existing H1B visas, increase in H1B visa fees, and increase in minimum wage
requirement for H1B visa employees could be a cost headwind for the sector.
The H1 window for FY18 would open on April 2017 and we see continued strong
demand this season as well. However, companies have already stepped up
initiatives on local hiring. We believe increased onsite hiring would be a margin
headwind for the sector over FY18‐FY20E. This is because onsite effort has lower
gross margins (vs. offshore). We also see scope for negative impact on onsite
utilisation owing to increased local hiring which would also be a margin
headwind. We believe that Indian IT vendors might aggressively focus on other
counter levers to negate the headwinds from onsite hiring. This would include
aggressive pyramid correction in offshore, rationalizing mid and upper end of
the management and further enhancing focus on automation initiatives.
March 09, 2017 12
Indian IT Services
Deals with Rebadging could also increase: There has been constant rhetoric in
the American media that Americans have lost jobs and wages are depressed for
Tech employees owing to cheaper staff coming from India on H1B visas. We
note the media rhetoric on layoffs at Disney and Southern Edison in which local
employees were replaced by H1B visa holders from Indian IT vendors has got
wide attention. We believe that corporations would be careful under
the Trump administration to avoid such situations as it could result in a major
backlash. Hence, we believe that Indian IT vendors would have to re‐badge
onsite employees as a part of deals. This could also remain a margin headwind.
Ceteris paribus, a 1% effort mix shift towards onsite hits gross margin by ~40‐
50bps. We also note that any restriction on H1B visas might heat up of the US
Tech job market which could put upward pressure on onsite salaries and hence
increase onsite salary costs for Indian IT vendors. Considering the strong
competitive intensity in the sector, Indian IT vendors might not be able to pass
these cost headwinds to clients in terms of higher billing rates
We note sector already has been suffering from margin challenges over the
past three years. However, steep rupee depreciation has been enabling
companies report a decent margin print.
Exhibit 15: Infosys and TCS EBITDA Margins (%)
24.0%
26.0%
28.0%
30.0%
32.0%
34.0%
1QFY14
2QFY14
3QFY14
4QFY14
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
Infosys TCS
Source: Company Data, PL Research
March 09, 2017 13
Indian IT Services
Exhibit 16: Wipro (Consol) and HCL Tech EBITDA Margins
18.0%
20.0%
22.0%
24.0%
26.0%
28.0%
1QFY14
2QFY14
3QFY14
4QFY14
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
Wipro ( Consolidated) HCL Tech
Source: Company Data, PL Research * Wipro EBIDTA margin show in the above exhibit is the consolidated EBIDTA margin ( Includes IT products business).
Exhibit 17: USD v/s INR Average rate over the past few quarters
56.6
62.8
62.0
61.5
59.9
60.662.2
62.163.6
65.4
66.1
67.7
67.1
66.9
67.7
51.0
54.0
57.0
60.0
63.0
66.0
69.0
1QFY14
2QFY14
3QFY14
4QFY14
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
Source: Company Data, PL Research
March 09, 2017 14
Indian IT Services
How would market react if TCS resets the margin band to lower levels?
TCS currently has a stated EBIT margin guidance band of 26‐28% and company has
been operating in this EBIT margin guidance band for over the past six years. With
softening USD revenue growth trajectory (~8.5% cc growth for FY17E), we believe
company is now in the growth‐margin trade‐off zone. TCS has the option to lower
the EBIT margin guidance band to 24‐26% and drive incremental investments to
chase growth. Incremental growth drivers could be further chasing emerging market
deals (especially in India, Latin America, Middle East where the margins could be
lower), increasing investments in Digital initiatives either organically or through
acquisitions. We believe that lowering margin guidance would not be a bad idea if it
can provide incremental impetus to the growth trajectory of the company and retain
absolute PAT growth CAGR over FY18‐FY20E. However, recent management
commentary post 3QFY17 results suggest that it would to continue to focus on
operating at the 26‐28% EBIT margin guidance band.
Exhibit 18: TCS Consolidated financial model
FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E FY19E
USD Revenues (USD mn) 6,339 8,186 10,171 11,568 13,443 15,454 16,544 17,620 19,302 21,223
Growth (%) 5.4% 29.1% 24.2% 13.7% 16.2% 15.0% 7.1% 6.5% 9.5% 10.0%
Average Exchange Rate(USD/INR) 47.4 45.6 48.0 54.5 60.8 61.2 65.6 67.4 67.0 66.0
Revenues (Rs bn) 300 373 489 630 818 947 1087 1187 1293 1401
Growth (%) 8.0% 24.3% 31.0% 28.8% 29.9% 15.7% 14.8% 9.2% 9.0% 8.3%
EBIT (Rs bn) 80 104 135 170 238 254 288 306 336 364
EBIT margin (%) 26.8% 28.0% 27.6% 26.9% 29.1% 26.9% 26.5% 25.8% 26.0% 26.0%
PAT (Rs bn) 70 91 104 139 192 217 242 264 286 311
PAT Growth 33.2% 29.5% 14.8% 33.6% 37.6% 13.3% 11.6% 8.9% 8.6% 8.6%
EPS 35.7 46.3 53.2 71.1 97.8 108.8 123.2 133.8 145.4 157.9
EPS Growth (%) 32.8% 29.9% 14.8% 33.6% 37.5% 11.2% 13.2% 8.7% 8.6% 8.6%
Source: Company Data, PL Research
“As I always said, the philosophy has been to go for growth but not at the cost of
margin. We believe that compromising on either one of those, thinking that the
other one will come, will result in us end up losing both.” TCS Board chairman N
Chandra in 3QFY17 concall.
March 09, 2017 15
Indian IT Services
Non‐linearity yet to show up in a big way
While Automation has been the focus area over the past two years, we believe that
focus should further intensify on this front. Hiring trends remain company specific.
As on 9MFY17, net employee addition of top 5 IT companies combined stood at
69,986 (v/s 58,190 employees in 9MFY16). However, most of the net addition for
9MFY17 was driven by hiring at Cognizant. Cognizant hired 27,200 employees for
9MFY17 (v/s 4,000 employees in 9MFY16).
Exhibit 19: Total combined Headcount of Top 5 vendors and Headcount growth YoY (%)
832 846 855 876 893 929
957 976 990 1,017 1,034
1,059 1,085
1,111 1,129
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
13.0%
700
800
900
1,000
1,100
1,200
1QFY14
2QFY14
3QFY14
4QFY14
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
'000s
Total Headcount (Top Five IT combined) YoY growth (%) (RHS)
Source: Company Data, PL Research
Exhibit 20: Headcount of Top 5 Indian IT Vendors
Headcount FY12 FY13 FY14 FY15 FY16 9MFY17
Infosys 149,994 156,688 160,405 176,187 194,044 199,763
TCS 238,583 276,196 300,464 319,656 353,843 378,497
Wipro 135,920 145,812 146,053 158,217 172,912 179,129
HCL Tech 82,464 84,403 90,190 104,184 104,896 111,092
Cognizant 140,500 162,700 178,600 217,700 233,000 260,200
Total Headcount 747,461 825,799 875,712 975,944 1,058,695 1,128,681
Source: Company Data, PL Research
Among Tier 1 peers, Infosys has shown the strongest efficiencies on automation.
Infosys net addition stood at 5,719 employees for 9MFY17 (v/s 17,196
employees added in 9MFY16). This represents a 66% drop in net addition for
9MFY17. For the 9MFY17, Infosys USD revenues grew by 8.2% YoY.
March 09, 2017 16
Indian IT Services
Exhibit 21: Net additions of Indian IT vendors
FY12 FY13 FY14 FY15 FY16 9MFY17
Infosys 19,174 6,694 3,717 15,782 17,857 5,719
TCS 39,969 37,613 24,268 19,192 34,187 24,654
Wipro 13,535 9,892 241 12,164 14,695 6,217
HCL Tech 9,044 1,939 5,787 13,994 712 6,196
Cognizant 29,300 22,200 15,900 39,100 15,300 27,200
Total Net additions 111,022 78,338 49,913 100,232 82,751 69,986
Source: Company Data, PL Research
Exhibit 22: Combined USD Revenue Growth YoY (%) Vs Headcount growth (YoY%)
5.0%
7.0%
9.0%
11.0%
13.0%
15.0%
17.0%1QFY14
2QFY14
3QFY14
4QFY14
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
Revenue growth (%) Headcount Growth (%)
Source: Company Data, PL Research
Over the past few quarters, both Revenue and Headcount growth has been
moderating in the sector. For Q3FY17, combined revenues of Top 5 IT companies
(TCS/Cognizant/Infosys/Wipro/HCL Tech) stood at US$14.04bn, up 6.5% YoY.
Assuming a cross‐currency headwind of ~200bps, we can assume that revenues for
the top five IT companies combined would have grow by ~8.5% YoY. The Headcount
for the top five IT companies combined stood at 1.12mn up 9% YoY.
We believe vendors have to focus on further moving utilisation rates upwards and
drive a lean operating model. Vendors are also aggressively deploying bots and other
automation tools to drive productivity. Hence, net addition in the sector could
continue to moderate over FY18‐FY20E.
March 09, 2017 17
Indian IT Services
Solid M&A strategy by Global IT vendors
Global IT vendors have been tactical in capital allocation which has also contributed
to their outperformance v/s Indian IT counterparts. While some Global IT vendors
chose to invest in acquisitions targeted at growth segment (Digital, Analytics, and
Cloud Implementation), few others (Atos, Capgemini CGI) used capital allocation to
gain scale and expand geographic reach.
Apart from acquisitions, select vendors have also hived off and sold commoditized
offerings (IBM exited BPO operations as well as sold some of its commoditized
Hardware Businesses). We present the revenue growth performance of global IT
vendors. Atos and Capgemini have also done strategic acquisitions which aided
higher revenue growth and achieved scale. While organic growth for both these
companies was in the range of 0‐2% over CY15/CY16, acquisition aided these
companies to report higher overall revenue growth.
Exhibit 23: Revenue growth for Global IT vendors
Revenues (USD bn) CY13 CY14 CY15 CY16
Global IT vendors
IBM Global Services 56.9 54.9 49.1 NA
Growth (%) (3.1) (3.6) (10.4) NA
IBM Total revenues 99.6 92.7 81.7 79.9
Growth (%) (4.7) (7.0) (11.9) (2.2)
Accenture* 28.6 30.0 31.0 32.9
Growth (%) 2.5 5.1 3.4 5.9
Local Currency growth (%) 4.0 5.0 11.0 10.5
HP Enterprises (Services Revenues only) 23.6 22.3 19.8 18.8
Growth (%) (5.5) (11.2) (4.7)
Capgemini 11.1 11.6 13.1 13.8
Growth (%) (1.7) 4.8 12.7 5.5
Atos 9.5 10.0 11.8 12.9
Growth (%) (2.6) 5.1 18.1 9.7
CGI Group 7.76* 8.08 7.91 8.2
Growth (%) 111.3 4.1 (2) 3.9
Source: Company Data, PL Research * Accenture follows August 31st year ending, Atos and Capgemini revenues are converted to USD at rate of (Euro to USD @1.1 uniformly across all years). Logica acquisition aided higher growth in CGI group revenues in CY13. Acquisitions also contributed to revenue growth at Accenture, Atos, CGI and Capgemini
March 09, 2017 18
Indian IT Services
Exhibit 24: YoY Revenue Growth of Global IT vendors (%)
CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16
IBM* 11.9 9.0 (6.4) 3.2 6.8 (2.1) (3.1) (3.5) (10.3) NA
Accenture 13.0 11.0 0.0 (2.0) 15.0 11.0 4.0 5.0 11.0 10.5
Capgemini 13.0 0.0 (3.8) 3.9 11.5 5.9 (1.7) 4.8 12.7 5.2
Atos Orgin 8.5 (4.0) (8.8) (2.1) 35.7 29.8 (2.6) 5.1 18.1* 9.5*
Source: Company Data, PL Research * For IBM, we have presented the services business only, Acquisitions contributed to higher growth in Atos Origin in CY11/CY12/CY15/CY16. For CY16, Atos Origin, organic growth is 1.8%.
Accenture: Accenture spent US$2.45bn in the past three years to acquire over
50 companies. Accenture indicated that 70% of the investments in acquisitions
were in boosting the new service offerings. The acquisitions aimed to
strengthen growth segments which include Cloud, Cyber Security, Analytics, and
UX Design etc. The M&A strategy has clearly yielded results with Accenture
growth over the last two years predominantly being driven by the Consulting.
Exhibit 25: Accenture acquisitions in the last few years
Company acquired
Period of acquisition
Rationale
Javelin group
May‐15 Expand footprint in Retail Industry (Strategic Consulting and Digital Transformation)
BrightStep Jun‐15 Digital Consulting company based on Digital Content
Tquila May‐15 Sales force Implementation capabilities Europe
Gapso Mar‐15 Advanced Analytics Capabilities in Brazil
Reactive Media
Dec‐14 Expand Digital Design capabilities in Australia and New Zealand
Axia Apr‐15
Strengthen expertise in cost management capabilities
Source: Company Data, PL Research
With Digital being one of the incremental growth drivers, Accenture has been
able to garner substantial mindshare from clients with robust offerings in these
areas. Hence, Accenture appears to better mine the accounts which is leading to
steady downstream revenues in outsourcing segment as well.
“Approximately 70% of these investments (acquisition related) were in “the
New.” Key examples in fiscal 2016 included Cloud Sherpas, a leading cloud
advisory and services provider; IMJ Corporation, one of Japan’s largest digital
marketing agencies and several European digital services companies, including
MOBGEN in the Netherlands, Tecnilógica in Spain and dgroup in Germany. We
are also investing to enhance our expertise in key industries through
acquisitions such as Sagacious Consultants in Health, Beacon Consulting and
Formicary in Capital Markets and Schlumberger Business Consulting and
Cimation in Energy” Extracts from Accenture Annual Report.
We note that 70% of Accenture’s
acquisitions are focused on “New
Technologies” which include Cloud, Digital
and Cyber Security
March 09, 2017 19
Indian IT Services
Exhibit 26: Consulting revenues and consulting as a % of revenues for Accenture (USD bn)
50.0%
52.0%
54.0%
56.0%
3.0
3.5
4.0
4.5
5.0
2QFY14
3QFY14
4QFY14
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
(US$ bn)
Consulting revenues As a % of Total Revenues (RHS)
Source: Company Data, PL Research
Exhibit 27: Consulting Growth of Accenture in Local currency
0%
5%4%
7%
11% 11%
14%15%
18%16%
13%
7%
0%
5%
10%
15%
20%
2QFY14
3QFY14
4QFY14
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
Source: Company Data, PL Research
Accenture has launched “Accenture Digital” by combining capabilities in
Accenture Interactive, Accenture Analytics and Accenture Mobility. Revenues
from Digital, Cloud and CyberSecurity contributed US$13.5bn annually
representing 40% of total revenues and are showing robust traction growing
30% YoY.
Exhibit 28: Similar acquisition strategies done by other MNC vendors
Year Company Acquired Amount Spent Rationale
Atos Dec‐10 Siemens IT US$1.1bn Increase Scale and Expand in Germany and Eastern Europe
Atos May‐14 Bull US$844mn Expand in Cloud and Cyber Security
Atos Nov‐15 Unify US$373mn Strengthening Collaboration business
Atos Jul‐15 Xerox ITO US$966mn expand into American Market
IBM Mar‐16 Bluewolf US$200mn Design and Cloud Services ( Sales force market)
IBM Jan‐17 Agile 3 NA Cyber security
IBM Truven Health US$2.6bn Patient Data and analytics
IBM Oct‐15 CleverSafe US$1.3bn Hybrid Cloud Competency
Capgemini Apr‐15 Igate US$4bn Expand into North American clients and boost Global Delivery
Capgemini June‐11 Praxis Technology NA Expansion into Chinese market
Capgemini Sep‐10 CPM Braxis, Expansion into Brazil
CGI Smith May 12 Logica US$2.8bn Expand presence in Europe
Source: Company Data, PL Research
Most of the acquisition strategies of Global IT vendors were focused on Digital,
Cyber security and Cloud. This has led to Global IT vendors gain a higher client mind
share on the Digital Consulting Business. Global IT services companies also pursued
tactical acquisitions to expand into geographies and gain scale (M&A strategy of Atos
and CGI).
March 09, 2017 20
Indian IT Services
Exhibit 29: Rating of Digital Strategy Consulting by a Leading Consulting
Source: Company Data, PL Research
As per the IDC report, leaders in Digital Consulting include IBM, McKinsey,
Accenture, Deloitte and Globant. Most of the players in Digital Consulting remain
dominated by Global IT companies. We believe that a strong acquisition strategy
has favoured Global IT vendors.
HP+CSC = Scale and Cost Synergies
While Accenture’s acquisition strategy was focused on boosting Digital, select other
global vendors focused on merger to drive scale and provide cost synergies. In May
2016, HP Enterprises and CSC announced a merger to create a global IT services
conglomerate. The Combined entity would have revenues of US$26bn annually (HP
Enterprises annual revenues at US$18bn for FY16 and CSC had annual revenue of
US$7.1bn for FY16 (April year ending). HP Enterprises and CSC have a headcount of
~1,30,000 employees and 59,000employees respectively. The combined headcount
of the merged entity would be ~190,000 (Of this ~45,000‐50000 would be in India).
While the deal is expected to close in March 2017, the combined entity would have
cost synergies of ~US$1bn per year. Both the stocks generated strong returns in
CY16 aided by this consolidation move.
“We will be able to consolidate delivery centres and leverage our position in India
and China and Costa Rica and other places” HP Enterprises CEO comments on the
deal with CSC.
Digital Strategy Consulting space continues
to be dominated by Global vendors which
include Accenture, IBM, Globant, Deloitte
and McKinsey
March 09, 2017 21
Indian IT Services
On the contrary, Capital allocation of Indian IT companies has remained company‐
specific. While Wipro has been most aggressive in acquisitions, TCS has been the
least. Tech M was also aggressive on M&A strategy but had some disappointments
on this front led by weak performance in LCC acquisition which dragged the
profitability of the company. HCL Tech’s partnership with IBM for the IP products
appears expensive in our view. HCL Tech guided that it would derive US$160mn in
annual revenues from IBM IP and spent US$550mn for acquiring the same. This
implies that the acquisition of IBM IP revenues was done at a P/S of 3.3x. Infosys’
major acquisitions over the past two years include Panaya, Skava and Noah
Consulting.
Exhibit 30: Acquisitions done by Indian IT companies
Vendor Year Company Acquired Amount Spent Rationale
Tech Nov‐14 LCC USD240mn Strengthen Network practice for the Telecom Vertical
Tech M Dec ‐15 Pininfinarina USD28mn Automotive design capabilities
Tech M May 16 Target USD164mn Platform offering in BFSI, Strengthen Tech M Positioning in UK Banking
Tech M Jan‐15 Softgen USD40mn Delivering Solutions in and around Core Banking
Wipro Jun‐15 Designit USD95mn Digital Design ( User Experience, Interactive Design)
Wipro Feb‐16 Healthnet USD460mn Business platform as a service for Healthcare
Wipro Oct‐16 Appirio USD500mn Implementing Cloud Services with competency in SalesForce
Infosys Feb‐15 Panaya USD200mn Strengthen Automation and Platform Initiatives
Infosys April‐15 Skava USD120mn Strengthen Platforms business of Infosys
Infosys Oct‐15 Noah USD70mn Strengthen Consulting Capabilities for the Oil and Gas Industry
Source: Company Data, PL Research * For Pininfarina, we note Tech would spent US$28mn for 76% stake and has also infused money into it
On the Digital front, we believe that Wipro is the only vendor which has done
sizeable acquisitions to boost capabilities on this front (Designit and Appirio). Select
other acquisitions of Indian IT vendors were aimed at boosting as As a Service
offerings (Health Net, Target etc).
Global IT companies have shown a clear edge over Indian IT counterparts on the
acquisition strategy. In our view, one limitation of Indian IT companies to
aggressively chase acquisition could be the possible dilution of margins as well as
cultural challenges which could lead to turbulence post acquisition.
March 09, 2017 22
Indian IT Services
Focus shifts on Capital Allocation Strategy
With growth moderating in the sector, focus has shifted to capital allocation
strategy. During the phase when USD revenue growth remained strong, investors
have not complained much on the high cash component on balance sheets.
However, growth slowdown over the past two years has led the focus to shift on
capital allocation. With strong demand from investors, sector has seen a slew of
companies doing tender offer based buybacks
(TCS/Wipro/Hexaware/Eclerx/Mphasis).
Exhibit 31: Total revenues of top‐5 Indian IT vendors (USD bn) v/s Revenue growth
7.9 8.6 8.9
9.5 10.1
10.9 11.5
12.2 12.7
13.2 13.9 14.0
4.0%
9.0%
14.0%
19.0%
24.0%
29.0%
34.0%
7.0
8.0
9.0
10.0
11.0
12.0
13.0
14.0
1QFY12
2QFY12
3QFY12
4QFY12
1QFY13
2QFY13
3QFY13
4QFY13
1QFY14
2QFY14
3QFY14
4QFY14
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
(US$ bn)
Total Revenues YoY gr. (RHS)
Source: Company Data, PL Research
Exhibit 32: Combined USD Revenue growth of top‐5 Indian IT vendors (YoY growth)
28.1%
22.9%
18.4%
15.7%
11.7%10.2%
11.1%12.2%
14.3%15.4%
14.2%13.6%13.4%12.3%11.8%
10.2%10.6%10.0%8.3% 8.9% 9.0%
7.2% 6.5%
6.0%
11.0%
16.0%
21.0%
26.0%
31.0%
1QFY12
2QFY12
3QFY12
4QFY12
1QFY13
2QFY13
3QFY13
4QFY13
1QFY14
2QFY14
3QFY14
4QFY14
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
1QFY17
2QFY17
3QFY17
Source: Company Data, PL Research
March 09, 2017 23
Indian IT Services
Exhibit 33: Revenue and revenue growth of top vendors
Fig in USD mn 1QFY15 2QFY15 3QFY15 4QFY15 1QFY16 2QFY16 3QFY16 4QFY16 1QFY17 2QFY17 3QFY17
Infosys 2,133 2,201 2,218 2,159 2,256 2,392 2,407 2,446 2,501 2,587 2,551
QoQ Growth (%) 2 3.2 0.8 (2.7) 4.5 6 0.6 1.6 2.2 3.4 (1.4)
TCS 3,694 3,929 3,931 3,900 4,036 4,156 4,145 4,207 4,362 4,374 4,387
QoQ Growth (%) 5.5 6.4 0.1 (0.8) 3.5 3 (0.3) 1.5 3.7 0.3 0.3
Wipro 1,740 1,771 1,795 1,774 1,794 1,832 1,838 1,882 1,931 1,916 1,903
QoQ Growth (%) 1.2 1.8 1.4 (1.2) 1.1 2.1 0.3 2.4 2.6 (0.8) (0.7)
HCL Tech 1,407 1,433 1,491 1,491 1,538 1,545 1,566 1,587 1,691 1,722 1,745
QoQ Growth (%) 3.4 1.8 4 ‐ 3.2 0.5 1.4 1.3 6.6 1.8 1.3
Cognizant 2,517 2,581 2,742 2,911 3,085 3,186 3,232 3,202 3,370 3,450 3,462
QoQ Growth (%) 3.9 2.5 6.2 6.2 6 3.3 1.4 (0.9) 5.2 2.4 0.3
Total Revenues 11,491 11,915 12,177 12,235 12,709 13,111 13,188 13,324 13,855 14,049 14,048
QoQ Growth (%) 3.5 3.7 2.2 0.5 3.9 3.2 0.6 1 4 1.4 ‐
YoY Growth (%) 13.4 12.3 11.8 10.2 10.6 10 8.3 8.9 9 7.2 6.5
Source: Company Data, PL Research
Capital allocation strategy of Accenture and Infosys
Accenture’s high ROE led by superior capital allocation
We have analysed key metrics in Accenture’s cash flows over the past four years. We
note that Accenture has been spending more than what it generates from FCF for
buybacks and dividends. This superior capital allocation has helped Accenture in
enjoying superior ROE of 60% for FY16. Accenture has been seeing a net reduction in
cash on balance sheet over the past few years. As on FY16, Accenture Cash on
balance sheet stands at US$4.9bn (v/s US$6.6bn cash as on FY12).
Exhibit 34: Key items in Accenture consolidated cash flows
Fig in USD mn FY13 FY14 FY15 FY16
Net cash provided by operating activities 3303 3486 4092 4575
Purchases of property and equipment (Capex) (370) (322) (395) (496)
Free Cash Flow from Operations 2,934 3,164 3,697 4079
Amount spent for Acquisitions (804) (740) (792) (932)
Free Cash Flow post acquisitions 2,130 2,424 2,905 3147
Share buyback (a) (2,544) (2,559) (2,453) (2,604)
Cash dividends paid (b) (1,122) (1,255) (1,353) (1,438)
Amount Spent on Buyback and Dividend (3,666) (3,814) (3,806) (4,042)
Source: Company Data, PL Research
However,Accenture’s absolute share count has not seen major reduction over the
years as Buyback strategy helped absorbed the dilution impact which has been
created from ESOPs. We present sharecount of Accenture and Cognizant.
March 09, 2017 24
Indian IT Services
Exhibit 35: Share Count of Accenture and Cognizant (mn)
Accenture (mn) FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16
Basic 610 623 639 647 643 645.5 634.2 626.7 624.7
Diluted 823 785 766 738 726 712.7 692.3 678.7 667.7
Cognizant (mn) CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16
Basic 580.2 586.6 601.4 606.6 602.6 604 608.1 609.1 607
Diluted 597.8 602.2 618.26 620.7 611.7 609.7 612.5 613.3 610
Source: Company Data, PL Research
On the contrary, despite already having a strong net cash position, Infosys continues
to see further cash accretion to its balance sheet which is dragging ROE. Despite
Infosys indicating 50% dividend payout ratio guidance, this translates to only 70‐80%
of free cash flows being paid in the form of dividend. We believe that Infosys should
start paying 100% FCF generated from here‐on as dividend. This would aid an
improvement in the return ratios.
Exhibit 36: Key metrics of Infosys
(Rs mn) FY10 FY11 FY12 FY13 FY14 FY15 FY16
FCF generated 60,430 46,040 65,710 62,310 94,420 72,230 87,730
Dividend Paid (Including Dividend Tax) 16,740 40,130 31,370 28,150 42,330 61,450 67,040
Dividend paid/FCF generated 27.7% 87.2% 47.7% 45.2% 44.8% 85.1% 76.3%
Net Cash on Balance Sheet 133,010 167,890 209,360 235,710 290,060 312,410 327,720
ROE (%) 30.1 26.6 27.4 25.7 24.9 24.1 23.2
Source: Company Data, PL Research
Net cash on balance sheet is Rs357bn as on Q3FY17. Our view is that Infosys can
return the cash on balance sheet to shareholders by doing a tender offer based
buyback in phased manner over a three year period. This would also aid in boosting
the ROE for the company as well as increase EPS over FY18‐FY20E predominantly led
by reduction sharecount.
March 09, 2017 25
Indian IT Services
Infosys: Aggressive share buyback scenario
Infosys’ current model is to distribute ~50% of PAT as dividends (including dividend
tax). However, this strategy has led to Infosys ending up further accumulating cash
on to balance sheet which continue to drag ROE (%)
Exhibit 37: Base Case Estimates for Infosys
FY15 FY16 FY17E FY18E FY19E FY20E
PAT (Rs mn) 123,328 134,900 143,541 156,930 170,241 188,951
EPS 53.9 59.0 62.8 68.7 74.5 82.7
Dividend Payout Ratio 50% 50% 50% 50% 50% 50%
Dividend Yield (%) 2.2% 2.4% 2.6% 2.8% 3.0% 3.4%
Net Cash on Balance Sheet ( Rs mn) 312,410 327,720 373,079 430,303 490,577 559,625
ROE 24% 23% 22% 22% 21% 21%
Source: Company Data, PL Research
Case Study 1: Aggressive Capital allocation model
Assuming, Infosys does a tender offer based buyback of ~Rs120bn every year over
the next three years (FY18/FY19/FY20E), it would help investors get a steady stream
of returns. Assuming the Buyback price at 1200/1250/1300/Share in
FY18/FY19/FY20E, Infosys will be able to reduce its share count by 12.5% by FY20E
(assuming no major dilution from ESOP’s). Over this period, we also assume Infosys
will continue its 50% dividend payout ratio. Hence, net cash on balance sheet will
reduce from Rs373bn in FY17 to Rs179bn by FY20E. However, Infosys ROE will surge
to 29% by FY20E (vs 22% as on FY17). We see EPS being upgraded by 1.3/3/4.5% for
FY18/FY19E/FY20E. Current regulations in India allow tender offer buyback to be
done only after a one year period post exhaustion of existing buyback plan. Hence,
an exact replica as discussed in this model might not be feasible. However, Infosys
should commit a strong policy to reduce share count.
Exhibit 38: Model Assuming a very aggressive Capital allocation by Infosys (Involves returning significant component of Cash)
Aggressive Capital Allocation Assumptions FY15 FY16 FY17E FY18E FY19E FY20E
PAT (Rs mn) 123,328 134,900 143,541 152,058 160,343 172,549
EPS 53.9 59.0 62.8 69.5 76.7 86.3
Dividend Payout Ratio (%) 50% 50% 50% 50% 50% 50%
Net Cash on Balance Sheet (Rs mn) 312,410 327,720 373,079 306,498 240,417 179,518
ROE(%) 24.1% 23.2% 22.0% 22.8% 25.6% 29.3%
Share count (mn) 2286 2286 2286 2186 2090 1997
Number shares bought through Tender 100 96 92.3
Price at which Tender offer is done ( Assumption) 1200 1250 1300
% Of Equity capital bought through tender 4.4% 4.4% 4.4%
Source: Company Data, PL Research
March 09, 2017 26
Indian IT Services
Indian IT vendors have de‐rated led by growth moderation
While select Global IT vendors (Accenture) have seen a steady re‐rating led by strong
growth and aggressive capital allocation strategy, the Indian IT vendors are
struggling due to slowdown in revenue growth trajectory. While valuations remain
attractive for Indian IT vendors, a strong capital allocation policy would be the key
over FY18‐FY20E shareholder returns as well as any re rating. We believe companies
with high margins and high free cash flows would be better positioned to return
higher quantum of cash to shareholders or do tender offer based buybacks. Infosys
and HCL Tech remain our preferred large cap picks. Hexaware and Persistent
Systems are our midcap picks. NIIT Tech is positioned as our value pick.
Exhibit 39: Valuation of Global IT vendors
Company Name Mcap (US$bn) P/E EV/EBITDA ROE (%)
CY16 CY17E CY18E CY16 CY17E CY18E CY16 CY17E CY18E
Atos 12.2 18.3 13.9 12.8 8.1 7.4 6.9 14.2 16.6 16.3
IBM 170 12.0 13.1 12.7 12.8 10.4 10.5 73.0 62.4 59.7
Accenture* 77.0 21.6 20.9 19.4 12.7 13.2 12.3 60.0 46.1 43.6
Capgemini 14.8 14.7 14.1 12.9 10.4 8.8 8.3 13.0 12.6 12.6
Source: Company Data, PL Research* Accenture follows 31st August Year ending . Hence , Accenture metrics are for FY16/FY17E/FY18E
Exhibit 40: Comparative Valuation of Indian IT Vendors
Adj. EPS dil. (Rs) P/E (x) ROE (%)
CMP Mcap (Rs bn) FY17E FY18E FY19E FY17E FY18E FY19E FY17E FY18E FY19E
TCS 2,505 4937 133.8 145.3 157.8 18.7 17.2 15.9 31.4 27.8 26.0
Infosys 1,020 2342 62.8 68.7 74.5 16.2 14.8 13.7 21.9 21.5 20.9
Wipro 492 1203 34.3 36.9 40.5 14.3 13.3 12.2 17.1 16.3 16.1
HCL Tech 855 1205 58.0 63.6 69.6 14.7 13.4 12.3 26.8 25.0 23.5
Tech M 498 484 33.9 39.4 43.9 14.7 12.6 11.3 19.6 20.1 19.6
Source: Company Data, PL Research
March 09, 2017 27
Indian IT Services
Valuations
Exhibit 41: Infosys one‐year forward P/E Chart
Source: Company Data, PL Research
Exhibit 42: TCS one‐year forward P/E Chart
Source: Company Data, PL Research
Exhibit 43: Wipro one‐year forward P/E Chart
Source: Company Data, PL Research
Exhibit 44: HCL Tech one‐year forward P/E Chart
Source: Company Data, PL Research
8
13
18
23
Mar‐13
Jun‐13
Sep‐13
Dec‐13
Mar‐14
Jun‐14
Sep‐14
Dec‐14
Mar‐15
Jun‐15
Sep‐15
Dec‐15
Mar‐16
Jun‐16
Sep‐16
Dec‐16
Mar‐17
P/E Mean
Mean + Std Dev Mean ‐ Std Dev
10
13
16
19
22
25
Mar‐13
Jun‐13
Sep‐13
Dec‐13
Mar‐14
Jun‐14
Sep‐14
Dec‐14
Mar‐15
Jun‐15
Sep‐15
Dec‐15
Mar‐16
Jun‐16
Sep‐16
Dec‐16
Mar‐17
P/E Mean
Mean + Std Dev Mean ‐ Std Dev
10
12
14
16
18
20
Mar
-14
May
-14
Jul-
14
Sep
-14
No
v-14
Jan
-15
Mar
-15
May
-15
Jul-
15
Sep
-15
No
v-15
Jan
-16
Mar
-16
May
-16
Jul-
16
Sep
-16
No
v-16
Jan
-17
Mar
-17
P/E Mean Mean + Std Dev Mean - Std Dev
4
8
12
16
20
Mar‐13
Jun‐13
Sep‐13
Dec‐13
Mar‐14
Jun‐14
Sep‐14
Dec‐14
Mar‐15
Jun‐15
Sep‐15
Dec‐15
Mar‐16
Jun‐16
Sep‐16
Dec‐16
Mar‐17
P/E Mean
Mean + Std Dev Mean ‐ Std Dev
March 09, 2017 28
Indian IT Services
Exhibit 45: Accenture one‐year forward P/E Chart
Source: Company Data, PL Research
Exhibit 46: Capgemini one‐year forward P/E Chart
Source: Company Data, PL Research
Exhibit 47: IBM one‐year forward P/E Chart
Source: Company Data, PL Research
Exhibit 48: Atos one‐year forward P/E Chart
8
9
10
11
12
13
14
15 Feb‐15
Apr‐15
Jun‐15
Aug
‐15
Oct‐15
Dec‐15
Feb‐16
Apr‐16
Jun‐16
Aug
‐16
Oct‐16
Dec‐16
Feb‐17
P/E Mean
Mean + Std Dev Mean ‐ Std Dev
Source: Company Data, PL Research
10
13
16
19
22
25
Feb‐14
May‐14
Aug‐14
Nov‐14
Feb‐15
May‐15
Aug‐15
Nov‐15
Feb‐16
May‐16
Aug‐16
Nov‐16
Feb‐17
P/E Mean
Mean + Std Dev Mean ‐ Std Dev
5
8
11
14
17
20
Feb‐14
May‐14
Aug
‐14
Nov‐14
Feb‐15
May‐15
Aug
‐15
Nov‐15
Feb‐16
May‐16
Aug
‐16
Nov‐16
Feb‐17
P/E Mean
Mean + Std Dev Mean ‐ Std Dev
8
9
10
11
12
13
14
15
Feb‐15
Apr‐15
Jun‐15
Aug‐15
Oct‐15
Dec‐15
Feb‐16
Apr‐16
Jun‐16
Aug‐16
Oct‐16
Dec‐16
Feb‐17
P/E Mean
Mean + Std Dev Mean ‐ Std Dev
March 09, 2017 29
Indian IT Services
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32.2%
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16.1%
0.0%0%
10%
20%
30%
40%
50%
60%
BUY Accumulate Reduce Sell
% of Total Coverage
BUY : Over 15% Outperformance to Sensex over 12‐months
Accumulate : Outperformance to Sensex over 12‐months
Reduce : Underperformance to Sensex over 12‐months
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