Cyient Q2 results: A good mix of growth, efficiency and valuation in IT space

Cyient reported a decent set of operating numbers for the September quarter even as the IT sector continues to be buffeted by strong headwinds. The company’s biggest revenue segment — aerospace — is going through a lean patch, but strengths in other segments like transportation, communication and healthcare have helped make up for the shortfall.

Q2 2018 result update

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Cyient’s quarterly sales rose 5.7 percent year-on-year helped by traction in both services (89 percent of Q2 2018 sales) and design-led manufacturing (11 percent of sales) businesses.

The services business clocked a 9.2 percent sales growth YoY in dollar terms led by transportation (+30.6 percent YoY) and communication (+16.3 percent) segments. This helped offset the weakness in aerospace (+3 percent), industrial (+1 percent) and utilities & geospatial (+3.7 percent) segments.

Weakness in the biggest segment — aerospace — (31 percent of Q1 2018 Sales), seems temporary as its key client UTC is focused on an M&A deal. The Cyient management is confident that things will return to normal by the end of this year.

Geography wise, EMEA and APAC region exhibited double-digit growth but Americas had a subdued 0.7 percent growth.

EBITDA margins improved by 55 bps YoY on higher revenue productivity (+7 percent YoY), higher offshore revenue and improved onshore margins. Wage hikes (70bps for Q2 FY18) were a drag, but much of it now behind.

Higher conviction in the growth outlook

We are positive about the robust performance of the DLM unit which is now on track to break even operationally by the end of FY18. Given the traction so far, the company is inching towards a double-digit earnings growth. The management has maintained its growth outlook despite headwinds in the aerospace division. Order intake was lower in the first half of this fiscal, but this is expected to improve in the second half.

The management expects a 50 basis point-improvement in operating margins on higher utilization and increased offshore business.

Structural sweet spot

As we mentioned in our earlier note, Cyient has a large exposure (about 54 percent) to relatively under-penetrated engineering services, with leadership in aerospace and transportation verticals and some very strong client relationships. In communication (20 percent of revenue), there are opportunities in the new network roll-out or upgradation. In the utilities and geospatial segments, Cyient’s business has been growing in advanced metering infrastructure, smart grid, smart meters and analytics. Each of these segments are relatively immune to the difficult transition that the traditional IT companies are undergoing.

Key clients undergoing M&A

Key concern for the company is that a few of its top clients are undergoing M&A (Siemens/Alstom, UTC/Rockwell) and the resultant uncertainty can impact order flows from those spaces.

Valuation

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The stock currently trades at 12.82 times 2019 earnings which is attractive in our view, given the above industry growth prospects.

As some of the key accounts are performing well, operational efficiency is on track and the management is optimistic about better traction in order intake in rest of the year, Cyient deserves investors’ attention, in our view.

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Bajaj Corp’s Q2 result: GST transition gets longer

Bajaj Corp, leading manufacturer in the light hair oil segment (61 percent of market share), was the first in the FMCG pack to report its September quarter earnings. As always, it brings to light early trends in the sector and, now more importantly, further updates on the GST transition. Unlike the much talked-about ‘V’-shaped restocking and a scenario of supply chain normalization by Q3, the industry appears to be grappling with a slightly longer transition.

Q2 2018: Weak margins though a probable refund would partially offset

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Bajaj Corp’s quarterly sales rose 3.8 percent driven by a 5.1 percent domestic volume growth of 5.1 percent (vs -7.8 percent in Q1 2018). International business sales was down 15.4 percent on account of continuing weak macroeconomic conditions in the Middle East and North Africa region. Domestic business witnessed a restocking-led growth but was still way behind expectations due to ongoing GST-led transition effect.

EBITDA margins dropped by 556 bps year-on-year on higher employee cost (9.5 percent of sales vs 7.5 percent in Q2 2017), higher sales promotion cost and other expenses. Light liquid paraffin (LLP), a key raw material, as well firmed up by 16 percent YoY. However, in case of further price escalation, management guided for minimal impact in near-term as the company has an inventory till December.

The company expects a refund of about Rs 6.4 crore as the manufacturing units under the tax free zones would continue to enjoy fiscal benefits as per recent announcement from government. This would improve the EBITDA margin to about 32.45 percent for Q2 2018.

Almond Drops Hair Oil: Volume uptick

Bajaj Corp’s key brand Almond Drops Hair Oil witnessed a volume uptick after three consecutive quarters of de-growth. The company’s market share in the light hair oil category has sustained around 58.3 percent, but company’s share in the total hair oil category is marginally slipping to 7.1 percent when compared to 7.2 percent in June 2018 and 7.4 percent in FY16. Thus, a subtle shift from light hair oil category to other hair oil category seems underway though recent supply chain issues are clouding clear inference.

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Distribution pain to linger

The company mentioned that most of the distributors are registered in the GST network but they are finding it onerous to follow up for returns. Key hurdle is the wholesale platform wherein about 1/3rd of wholesalers have not yet started purchasing under the new regime. So the key issue for the company is supply-chain hassles.

As sales growth is 7.4 percent and the end consumer offtake is 4.8 percent, so in balance there has been some restocking. Interestingly, a bulk of this restocking happened in July and has not continued since.

Clearly, a section of supply chain participants are in a wait-and-watch mode. In light of this, the company is aggressively focusing on enhancing direct distribution channel.

CSD (Canteen Stores Department) channel facing structural decline

CSD channel (~4 percent of sales) continue to face de-growth. After 46 percent YoY decline in sales in Q1 2018, CSD channel witnessed de-growth of 21 percent in Q2. Even for stores where inventory level is minimal, orders have been slashed which indicates a structural change. In our earlier interaction with FMCG companies, it was pointed out that going forward CSD sales contribution would diminish as government wants to plug the sales spillover to mainstream market.

Inorganic growth market share targets

Management reiterated that they are still looking at inorganic growth opportunity but didn’t provide any further details to it. It is noteworthy that the company has a shareholders’ approval for raising Rs 1000 crore.

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Inexpensive valuation but for a reason

Stock trades at an inexpensive multiple of 27.4x trailing earnings and a near-term rerating is possible if company pursues a credible inorganic route. Having said that company’s ongoing business lacks growth momentum.

Further, in light of supply chain disruptions, we are not enthused about the volume uptick and would wait for sustained traction to acknowledge any turnaround. Wholesale channel and GST-related disruptions, weak offtake in rural areas and the lower share in total hair oil market make us cautious on the stock.

 

TCS Q2: Transformation underway, but it is still a long road ahead

TCS has flagged off the earnings season for the technology sector on an upbeat note. Margins were better than expected and digital revenue contribution increased, which should lift sentiment for the sector as a whole.

Management appeared upbeat on transformational changes in key segments like retail and BFSI, but cautioned that a turnaround in those segments would take time.

Q2 2018 result update

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Source: Moneycontrol research

TCS’ quarterly results was ahead of consensus expectations with dollar revenue growing 8.3% year-on-year(7.1% at constant currency). On a quarter-on-quarter basis dollar revenue grew by 3.2% backed by a similar growth in volumes.

Among the end markets, higher YoY revenue growth in constant currency terms was contributed by energy and utilities, travel and life science partially offset by retail and BFSI. Digital revenues grew 31% YoY (5.9% QoQ) basis in constant currency terms and now contribute 19.7% share in total revenue (vs. 18.9% in Q1 2018). Among regions, the North American market (51.9% of Sales) posted 3.6% YoY growth lower than rest of the geographies.

Operating profits witnessed margin expansion of 170 bps (QoQ basis) on account of the normalization of wage and visa cost.

Key end markets – What’s in store?

While TCS’s operational performance improved, two of the largest segments of the company – BFSI and retail (45% of sales) continue to witness below par growth. Management, however, underlined transformational changes both the end markets/clients are going through which can benefit large IT players having expertise in the whole value chain of IT solutions.

In the case of retail industry, TCS pointed out that customers are evolving from a phase when e-commerce only format was seen as winning. Traditional retailers are coming out with a value proposition which pure e-commerce players may find difficult to match. Interconnected retail is the case in point, where in seamless client servicing is across store, online formats and meets consumers varied requirement. A format like this would require a large IT company to provide an integrated solution rather than a point solution. The management said home improvement and electronic retailers were moving to such solutions.

Chart: Interconnected Retail

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Source: Home depot

Similarly, in the banking space, open banking IT platform which is open to various to fin-tech adoption is gaining weight and this trend also requires a comprehensive IT solution.

Having said that such changes are at the nascent stage and various experimental models would evolve with time. It is here that TCS’s prudent investment in newer technologies and human resource would be tested.

New deals

In notable recent deal wins, Diligenta, a TCS subsidiary in UK, has secured a 15 year partnership with Scottish Widows, Lloyds Banking Group’s Life and Pensions business. As of now, details on the deal are awaited.

In general, the digital deals size is increasing in few areas like IOT (Internet of Things), Cloud computing segments but still larger share is from the smaller deals.

Elevated valuation

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Source: Moneycontrol research

Quarterly result and management commentary adds to our earlier assessment that TCS is inching ahead with its technological transformation journey. We take notice of new insights in evolution and adaption of newer technologies. However one has to keep in mind that it would take time for the digital revenues to drive overall growth.

In light of structural changes IT sector growth is going through and the relatively uncertain earnings visibility, the valuation at 17.7X FY18 projected earnings seems elevated in our view.

Global economy looking up but India on a slow lane – how should market read this?

In its latest report, IMF has estimated that all major economies in the world will grow, even as it downgraded India’s growth. It has revised upward the growth estimates for the Euro area, Japan, China, Russia and emerging Europe, compared to July update. But India received a major downward revision.

A downward growth revision wasn’t totally unexpected in light of transitional effects of twin policy initiatives of GST and demonetization. Though IMF expects a rebound in GDP growth rate next year, new projections are lower for next year as well (7.4 percent vs. 7.7 percent earlier).

Overall, broad-based global growth recovery brings good news but disappointments on the domestic front lead us to look at India’s contribution in global growth and the impact of commodity movements for a net importer like India.

Global growth inching up: Advanced economies lead

IMF’s review on global growth is positive wherein it observed firmer domestic demand growth in advanced economies as well as China.

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Source: IMF

Amongst advanced economies, the Euro area and Japan, in particular, benefitted from consumption and external demand. Major emerging markets like Brazil, Russia and east Asian markets also saw improvements on account of better external demand.

India – a better tomorrow but limited contribution to global growth

As per IMF, in the medium term, India is expected to grow above 8 percent in the medium term and its contribution to world’s GDP growth looks noticeable when seen in the context of purchasing power parity. (Purchasing power parity: the adjustments needed to be made in the exchange rates of two currencies to make them at par with the purchasing power of each other).

However, India’s contribution to global growth seems modest, particularly when compared to its closest EM peer – China. As per IMF, India’s contribution to GDP growth is only 19 percent of the overall contribution by advanced economies and only 21 percent of that by China. Even after a higher projected GDP growth rate for India and the structural changes China is going through, by the year 2022, India’s contribution to global GDP growth would be less than 1/3rd that of China.

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Source: World Economic Outlook, Oct-2017 – IMF

Who contributes to global growth?

As per our back-of-the-envelope calculation, India’s contribution to world’s incremental GDP growth is expected to be about 4 percent in 2018. However, China, despite its structural course correction, would have a 23 percent share of the world’s incremental GDP growth. Hence, the bulk of the emerging market share in global GDP growth would continue to come from China.

Advance economies particularly, the USA, Euro area and Japan would contribute 40 percent of incremental global growth in the coming year. This basically underscores the macro recovery comfort that global equity markets are pricing in. Recent economic fundamental data also point towards same direction.

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Source: IMF, World Bank, Moneycontrol Research

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Source: IMF, World Bank, Moneycontrol Research

Windfall from oil no longer available for India

The IMF report analyses the impact of commodity price trends on commodity exporters and importers. World economic outlook highlights that India, being one the key beneficiaries of lower oil prices in last few years, has accrued windfall gains in 2015 and 2016. However, in 2017 and 2018, it is projected to have loss of 0.43 percent of GDP due to higher oil and commodity prices.

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Source: IMF

While the IMF expects crude oil prices to settle around USD 50 in 2018, one of the implications is that windfall gains available in the past in the form of higher disposable income would not be available in the foreseeable future.

Xi Jinping’s marathon speech suggests more balanced growth in China, has positives for global economy

With a marathon three-and-a-half-hour-plus speech, President Xi Jinping kickstarted the 19th National People’s Congress in China, an event which also marks the start of his second five-year term as a party leader. Xi’s speech made a pitch for a comprehensive reforms ranging from a supply-side revamp to opening of financial markets, enforcing pollution norms and strengthening state enterprises. While China is mid-way through a course correction, Xi is in favour of “quality” growth as reforms unfold.

Goal “moderately prosperous society” by 2020

Xi reiterated goal for achieving “moderately prosperous society” by 2020 along with an emphasis on structural reforms for almost every facet of the socio-economic set up. The implication here is for the “soft landing” of the Chinese economy along with reforms on both domestic and international fronts.

Chart: China’s investment as a % of GDP is expected to decline further

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Source: IMF

While this points to a continued structural rebalancing for the Chinese economy (from investment-led to domestic consumption-led), it brings with it positive takeaways for the world economy as well.

Domestic reforms

Xi laid out that development is “unbalanced and inadequate”, adding that the quality of growth and not the speed was the priority. Global strategists read this as a sub-7% GDP growth rate for the medium term.

To defend against systemic risks, Xi talks about strengthening of SOEs (state owned enterprises). Along with this, he mentioned the need for industrial innovation, opening of the services sector and further lowering of barriers for foreign businesses. He saw the need to caution on speculative activity in the housing market, hinting at some policy steps which could ease the systemic risk of a housing bubble. At the same time, he reasserted his priority of “zero tolerance” for corruption.

Supply-side reforms to bring positive context for the commodities, chemicals

In his speech, Xi emphasised on the sustenance of supply-side reforms, which include reducing overcapacity in commodities sector, trimming housing inventory, and deleveraging. Along with this, his emphasis for controls over environmental issues means an ongoing demand-supply rebalancing in the global commodities can continue.

Further, specific segments in the industrial and chemical businesses in China can witness continued supply cut down due to non-adherence to pollution norms.

In this context, investors in India can continue to keep an eye on companies operating in steel, aluminum, dyes, pigments, graphite electrodes and plastic processing industries.

Currency reforms to unfold

Xi also mentioned about the reforms in financial markets eyeing interest-rate and currency reforms. Market participants expect new announcements in the direction of yuan internationalization after the NPC.

Overall, the inauguration speech lays down a broad context and direction for the Chinese economic growth trajectory.

This is important in global context, as a reform-oriented China with a stable growth trajectory takes away the fear that led to stock market ructions in 2015-16. A structural rebalancing in China, which is expected to contribute 1/4th of global GDP growth in 2018, acts as a balancing act for global economic growth.

India Inc’s first quarter post GST: Here’s a sector-wise review of early results

While still early days, GST implementation challenges and weak consumer sentiment have been the broad themes of India Inc’s second quarter earnings.

Consumption-oriented sectors like media and FMCG testify to the supply chain disruptions and guarded spending on promotions. Others like financials and telecom continue to grapple with structural transitions.

Having said that, corporate honchos are hopeful of a rural recovery and consumption revival during the festive season. Given this context, we analysed the Q2FY18 results so far for the early takeaways.

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Auto/Auto ancillary

The feedback is positive for firms supplying components to commercial vehicle (CV) and tractor makers. Tractor sales, in particular, seem to be on the rebound on the back of a good monsoon, agriculture credit schemes by the government, increase in farm profitability, and improved irrigation intensity.

For exports, North America and Europe will be the key markets for tractors given the consistent rise in demand for agro machinery and farming equipment in these continents. Exports to the Middle East and African regions, however, are unlikely to rise much in the near future.

A strong rupee vis-à-vis the US dollar may dent quarterly margins year-on-year.

Banking

Except for IndusInd Bank, where the non-performing assets (NPAs) were stable and slippages declined, bank earnings so far have been disappointing. NPA numbers of Lakshmi Vilas Bank and Axis Bank numbers were higher than what analysts expected. In case of South Indian Bank, slippages were high in absolute terms despite being lower on a sequential basis.

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Broadcasting & media

Q2FY18 revenues are expected to be sub-par as businesses struggled with the nuances of GST and manufacturers remained cautious about advertising in an uncertain environment. Start of the festive season, favourable consumer sentiment, and active ad spends (aided by better viewership) will be some of the key drivers that may benefit media companies in Q3FY18. The effectiveness of measures undertaken to promote regional content (news and entertainment) will be another factor to watch out for.

FMCG

In terms of volume growth, FMCG companies reported a mixed set of numbers. While Bajaj Corp witnessed a rebound, Colgate’s volumes dropped. Both companies highlighted that supply chain normalisation is far from over. In light of this, Bajaj Corp is aggressively focusing on enhancing its direct distribution network. Colgate, which has been facing immense competition, is focusing more on ayurvedic variants of toothpaste.

Housing finance

Management commentary suggests that supply of affordable houses is yet to pick-up meaningfully, barring Gujarat. A noticeable increase in housing finance will be visible only when the government’s schemes gain pace in other large states like Maharashtra, Madhya Pradesh, and Rajasthan. Lack of adequate corporate lending prospects have forced public and private sector banks to up their ante in this space, thereby intensifying the competition.

Information Technology

IT results have been a reflection of ongoing changes in the sector. TCS’s margins were positive as the contribution from its digital revenue segment rose to 20 percent of sales. However, growth prospects in the BFSI and retail segments remain muted for the industry in general. Wipro’s numbers weren’t too good either, as the company was impacted by weakness in the healthcare market. Lower guidance for Q3FY18 was a disappointment as well. Cyient looks like an interesting pick, given its near-term margin improvement prospects and performance of the end markets that the company caters to.

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Oil & gas/Petrochemicals

Reliance Industries reported an operationally good quarter with mixed surprises.  Petrochemical margins of the company were good owing to an uptick in volumes and pricing. The quarter-on-quarter increase in refining margins was not to the extent expected by analysts. While this is a positive takeaway for other petrochemical companies, indications of margin pressure seem apparent for the downstream chemical/plastic processing companies.

Paints

Nerolac reported a healthy 20 percent volume growth in the decorative coatings segment (which constituted 55.5 percent of FY17 sales) on the back of restocking and pre-festive buying. While this augurs well for its peers (Berger Paints and Asian Paints) in the segment too, Nerolac’s high raw material costs (59.8 percent of sales in Q2FY18 vs 57.3 percent in Q2FY17) will remain a cause of concern in the context of a elevated titanium-dioxide prices.

Telecom

Reliance Jio’s posted a profit at the operating income level. Despite the aggressive pricing, Reliance has been able to report an average revenue per user (ARPU) of Rs 156.4, which is comparable to other players in the industry. The telecom industry as a whole is witnessing stiff pricing competition, and high overheads may continue to weigh down profits. The speed and efficiency of integration of multiple revenue streams (such as cellular, home broadband, and entertainment) will also play a pivotal role in determining the breakeven trajectory for telcos in the long-term.

Anubhav & Krishna

Early Diwali for Future Retail & Shoppers Stop as HyperCity changes hands

One of the biggest deals in the retail space got announced with Kishore Biyani’s Future Retail deciding to acquire Shoppers Stop’s HyperCity arm. The transaction value, pegged at Rs 655 crore, will be paid by Future Retail through allotment of shares worth Rs 500 crore to HyperCity’s existing shareholders, in addition to Rs 155 crore in cash.

While the deal value, prima facie, looks muted, Shoppers Stop gets rid of a pain point and can focus on maximizing gains from its relationship with Amazon. For Future Retail, 1.3 million square feet addition (close to 30 percent of Future Retail’s existing area) helps it to augment capacity in one stroke and position its offerings in a premium format, thereby paving the way for a speedier turnaround of beleaguered HyperCity.

Deal contours

In its intimation to BSE, Future Retail laid down the contours of the agreement. The equity aspect includes issue and allotment of 9,310,987 shares (1.9 percent of Future Retail’s share capital) at a price of Rs 535 per share, amounting to Rs 498 crore. HyperCity’s debt, amounting to Rs 265 crore, would be transferred to Future Retail. After making adjustments for cash and cash equivalents, the enterprise value of HyperCity is roughly Rs 916 crore, implying an EV/Sales multiple of 0.79.

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While the deal value is at a discount to the valuation of Future Retail (1.57x EV/Sales) and Shoppers Stop (0.98x EV/Sales), as stated in detail in an earlier article, both companies stand to benefit by virtue of this development.

Shoppers Stop gets a clear roadmap

With HyperCity now off its books, Shoppers Stop’s efforts will be solely directed at its forte of retailing home accessories and apparel. Furthermore, the recent tie-up with Amazon will enable Shoppers Stop to enhance its online brand visibility, among the other benefits, as stated in one of our previous reports.

The retail major’s consolidated financials that were negatively impacted by HyperCity’s performance over the years, could witness some relief on back of better EBITDA (a negative EBITDA business segment will no longer be a drag) and bottom-line margins (debt repayment to be effected through proceeds received from sale of HyperCity and investments from Amazon).

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Amazon’s hunt for a grocery partner continues

While Amazon succeeded in joining hands with Shoppers Stop to build its brick and mortar store presence across India, they are likely to leverage this relationship in product categories that are closely identified with Shoppers Stop.

Amazon has been scouting for a partner for foraying into food and grocery retailing, and it may be interesting to see who fits their bill.

HyperCity could turn out to be the premium/differentiated format for Future Retail

HyperCity’s impetus is clearly greater on metros catering to the upwardly mobile population, whereas Big Bazaar, the flagship brand of Future Retail, is oriented towards the mass affluent category. The product categories and pricing of these two formats are different.

The cash outgo for the deal is only Rs 155 crore and Future Retail can fund this easily from its internal sources without resorting to additional debt.

While it is premature to put a timeline on the turnaround of HyperCity, Biyani has his plans chalked out to make the deal value accretive for the shareholders early.

The best practices adopted in its existing retail formats would find application in HyperCity as well. Future Retail’s plan is to rename a few HyperCity stores to Big Bazaar Gen Nxt in the immediate future owing to a good brand following in the case of the latter. Secondly, the company aims to actively commence Fashion Big Bazaar sales from the remaining HyperCity stores to cash in on the growth prospects in the value fashion segment.

Krishna Karwa & Anubhav Sahu

Moneycontrol Research