Nasscom sees modest rise in FY19 technology growth

Nasscom has guided for IT services exports growth of 7-9% in c/c for FY2019 as against 7% likely to be achieved in FY2018. Nasscom expects a better economic environment and deals signed by the industry to help elevate growth trajectory, especially towards the second half. We believe that FY2019 growth will be better than FY2018 though not as steep as the Street is building in estimates. Our recommendation bias is towards companies that have low implied growth acceleration baked into stock prices; Infosys and Tech Mahindra fit the bill.

7-9% exports growth: Nasscom

Nasscom expects FY2018e revenue growth of 7.8% in USD terms for the IT industry. We believe this translates into 7% growth in c/c in FY2018. In absolute terms, industry will add ~$8 bn of revenues in c/c. Nasscom expects FY2019e growth at 7-9% in c/c. This guidance implies absolute revenue addition of $9-11 bn, implying higher absolute revenue addition when compared to FY2018. Nasscom believes that a strong macroeconomic environment in developed markets will translate into better growth but with a lag. The industry body expects upswing in growth to start towards 2HFY19 after a gradual build-up over the next two quarters.

Big gap in headcount addition and industry growth

Nasscom expects net headcount addition of 100K in FY2019, similar to number of FY2018e. Headcount addition of just 3% in FY2019e is in stark contrast to exports growth guidance of 7-9%. We are surprised at the muted headcount addition expectation in FY2019, especially noting that Indian IT companies have taken up utilisation considerably in FY2018. Such a dramatic improvement is clearly not our base case assumption. Such a disconnect implies a material onsite shift in revenues or embedding of Mergers & Acquisitions expectation in the guidance.

Captives are growing faster than third party players

We believe that client captive centres have grown faster than third party players in FY2018e. This view is partly supported by the fact that growth of Tier 1 players at an aggregate level is lower than FY2018e industry exports growth. We believe that growth for third party players will hinge to some extent on sourcing strategy dynamics of clients; any accelerated shift to captive centres will certainly have negative implications for Indian IT. Our base case assumption is that the impact of insourcing/captive centres in FY2019 for Indian IT vendors will be lower than in FY2018.

Quantum of improvement in demand seems to be lower than Street’s expectation

While the FY2019 growth build-up is promising, the magnitude of acceleration seems to be lower than expectations based on CTSH and Nasscom guidance. We expect modest acceleration in growth rates in FY2019. A strong economy across key markets, low unemployment in the United States, rising interest rates and an environment supporting growth for IT spends in the banking vertical bodes well for Indian IT. A strong macro is a necessary condition for change in the direction of growth for Indian IT but not a sufficient condition as evidenced in growth deceleration in FY2018e. Three factors provide a decisive edge — (i) industrialisation of digital, (ii) better deal flow, and (iii) improved decision making. Our recommendation approach is to back companies that have low implied growth acceleration built into stock prices. Infosys and Tech Mahindra fit the bill nicely and are among our top picks in the sector.

Set-up for FY2019 is promising

We believe industry-wide acceleration in growth rates is possible in FY2019. This view is based on two key factors — (i) lesser drags and (ii) more deal closures. The key end-user industries that are clients of Indian IT are performing well. The retail segment is finally finding its bearings after being hit by the Amazon effect. Other verticals are also in a reasonable shape. IT spending by BFS clients is healthy though incremental spends are being directed internally. However, a better spending environment itself is not enough for growth acceleration. The Indian IT industry witnessed this in FY2018e wherein IT spending was robust but that still led to deceleration in growth rates.

We believe the following additional considerations also matter, all of which indicate a possibly better year for Indian IT ahead: (i) industrialisation of digital; (ii) better deal momentum; (iii) better decision making cycles; (iv) captive shift and insourcing impact. Of the four factors above, three have turned for the better. The impact of change in sourcing strategies could linger for a bit longer. The net impact of the above factors will be positive for Indian IT.