Stock Update: KEC International; Sector Update: Q4FY2017 earnings preview - IT

Stock Market Update

KEC International
Reco: Hold
PT: Rs 230
CMP: Rs 214

Steep appreciation in stock price of ~36% within few weeks; downgrade to Hold as of now: KEC International’s stock price has risen by a steep ~36% after our “Buy” recommendation at Rs 169 in Stock Idea dated March 14, 2017. The stock has crossed our price target of Rs 230. At the current market price, the stock is trading at a multiple of 14x average of FY 2018 E and FY 2019 E EPS. 

Outlook and valuation: Remain positive over medium term; downgrade to Hold PT to be reviewed with Q4 FY 2017 result update: We estimate KEC’s earnings to compound at a CAGR of 33.5% during FY 2016 - FY 2019 E, driven by an 8.9% revenue CAGR. 

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IT Sector Reviews

Expect another soft quarter, FY 2018 outlook holds the key

Q4 FY 2017 result expectations

A soft quarter: After a soft Q3 FY 2017, we expect the overall performance of the Indian IT companies to remain muted in the January-March 2017 quarter too, owing to seasonality issues, weakness in client spending, delay in decision-making process due to protectionist measures announced by the new US regime, absence of rupee benefits (appreciation of INR against USD) and continued pricing pressure.

We expect the cross-currency tailwinds (20-80 BPS) to drive USD revenue growth by 0.8-4.5%, whereas the constant-currency (CC) revenue growth will be in the range of 0.4-4.2% (0-1.5% in organic terms). 

Key issues to watch out for would be: 

(1) FY2018 revenue growth outlook by Infosys (expect 7-9% YoY CC revenue growth guidance), HCL Tech (expect to guide for a 11-13% YoY CC revenue growth, including revenue from acquisitions) and Wipro (expect revenue growth guidance of ~1-2% QoQ for Q1FY2018); 

(2) Commentary on margin trajectory and pricing outlook (pricing pressure is evident in deal renewals due to the commodification of legacy services); 

(3) Commentary on CY2017 annual IT budgets, budgeting cycle for verticals like Healthcare and outlook trend on verticals like BFSI; 

(4) Measures to mitigate risk from the potential increase in minimum wage for H1-B visa workers; 

(5) Commentary on positioning in the new-age digital/platforms/automation technologies and their growth prospects and 

(6) Management views on capital allocation strategies. TCS, HCL Tech and Wipro have already announced share buyback plans.

Protectionist measures along with rupee appreciation to be challenging in near-to-medium term: In Q4FY2017, the performance of the top IT companies will remain muted, owing to softness in client spending, account specific issues, rupee appreciation and seasonally weak quarter. 

TCS, HCL Tech and Wipro have already announced their share buyback plans recently, whereas Infosys has amended the Articles of Association (AoA) for a share buyback proposal.

Though the valuations of Indian IT companies look inexpensive (trading below their historical P/E multiples), we continue to remain selective in terms of our preferred picks in the IT sector, as these companies are investing and building new-age technologies in an efficient manner for driving sustainable growth in the coming years. Given that valuations are reasonable and a major de-rating is already behind, we see select buying opportunity from a long-term perspective (12-15 months time horizon).

Preferred picks: HCL Tech and Infosys (in large-cap space) and Persistent Systems (in mid-cap space).