Stock Recommendation | Wipro - REDUCE - Target price : 325

We find the current quarter performance encouraging, especially with a bit more broad-basing of growth from the earlier financial services-led one. Sustainability is the key factor to watch for. The company's competitive positioning has weakened in communications and manufacturing verticals, while healthcare verticals continue to be weighed down by ramp-down of HPS platform business. Wipro has also missed a trick of not capitalizing opportunities in utilities segment of E&U early enough and faces aggressive competition from TCS and Infosys. Financial services is the bright spot for the company with a mix of digital and traditional deals. Wipro has guided 1-3% revenue growth for December 2018 quarter, consistent with our expectations.

Wipro's performance has improved after multiple quarters of disappointment. Improvement is due to an uptick in industry demand and specific measures taken by the company. Two factors will determine stock returns from here-consistency in execution and signs of defending its leadership in core areas of competence. The company has not displayed these signs yet, which precludes it from becoming a part of the core portfolio. However, the stock can always be a good trade; it could be one after a good September 2018 quarter results. Our EPS estimates remain largely unchanged; our estimates had already baked in normalization of EBIT margin to ~18% by FY2020-21E though the pace of normalization has surprised us. Retain rating and target price, valuing the company at 14X September 2020E earnings.
Our revenue estimates decline due to segment reclassification undertaken by the company even as our underlying revenue estimates increase by 1-2%. Wipro has restructured India business wherein it has carved out India public sector undertakings (PSU) and India government business as a separate unit and which will not be part of IT Services segment. This change will have an US$34 mn impact on IT services quarterly revenues starting December 2018 quarter. We believe this business is lossmaking and hence will have a positive impact on IT services' absolute EBIT as well as margin. Our underlying EPS estimates increase for FY2019E though a one-time settlement of claim from National Grid (a client belonging to the energy and utilities vertical) leads to a cut in reported EPS

Wipro's 240 bps sequential increase in EBIT margin surprised us positively. Management expects EBIT margin to move in a narrow band in the near future. Analysis of segmental margin shows a few interesting trends-(1) financial services EBIT margin barely increased by 10 bps qoq despite strong tailwind of growth, currency and operational improvements, (2) relatively underperforming verticals in the quarter such as technology, manufacturing and healthcare showed 290 bps, 680 bps and 310 bps sequential increase in EBIT margin. In fact, costs in these verticals declined in absolute basis. We believe that part of the margin increase can be attributed to performance improvement and cost rationalization of global subsidiaries, which tie in with these industry unit P&Ls and (3) consumer business unit EBIT margin increased 580 bps sequentially and is somewhat difficult to explain.
On a broader basis, the variation in profile of margins across verticals captures the depth, relevance, execution and growth momentum across verticals. Wipro has scale and depth in financial services, E&U, consumer business and technology segment, middling in healthcare and sub-scale in communications.

Wipro's local headcount in the US has crossed 60%. Increase in local headcount will aid demand fulfillment and project execution. The company indicated that H-1B visa constraints have not impacted its ability to staff projects in the US. The company has demonstrated remarkable improvement in localization initiative and reduced risk from potential change to visa rules in the US.

▶ Margin walk-through. EBIT margin increased sequentially by 250 bps to 18.1% due to (1) ~90 bps tailwind from performance optimization of global subsidiaries, (2) ~90 bps tailwind from automation and productivity improvement and (3) 70 bps tailwind from rupee depreciation net of cross-currency movements.
▶ Guidance. Wipro has guided IT services revenues in the US$2,028 mn-US$2,068 mn range excluding India PSU and India government business revenues. This translates to a 1-3% sequential growth on a like for like basis.
▶ India business reorganization. Wipro has taken out its India PSU and India government business, which contributed US$34 mn revenues in the quarter, from its IT services classification (change effective from next quarter). Wipro maintains its enterprise business in India under IT services. India PSU and government business had a lower margin than the company average. Management reported that margin improvement of IT services due to the reorganization was negligible.
▶ Geography-wise outlook. Demand has picked up in all industry segments in America. APAC and emerging markets have witnessed good growth momentum. Middle East business has stopped declining. Continental Europe business has a strong pipeline. Europe continues to see slight headwinds to demand.
▶ Vertical-wise commentary. (1) BFSI-growth is spread across geographies and subverticals. BFSI has higher proportion of digital business since it was an early adopter of technology, (2) communication-early signs of growth in new areas like 5G and traditional areas such as enterprise services, (3) healthcare-headwinds related to HPS platform revenue persist, (4) E&U-growth in the vertical is reviving, (5) consumer-fairly good growth in the vertical, (6) manufacturing-Wipro is working towards getting sustainable growth from the vertical.
▶ Healthcare vertical. Headwinds and uncertainty continue to impact ACA revenues. The company reported that it has found early success in its efforts to build adjacent lines of business. The company expects normalized growth in the next 2-3 quarters. Open enrollment for insurance programs in the US occurs in the third quarter and will give more visibility to revenues from the vertical.
▶ Localization. Wipro maintains about 60% localized workforce in the US. IT has opened a training hub and runs an apprenticeship program in the UK for training fresh University hires. Wipro plans to maintain a strong localized workforce in the UK, Continental Europe and other high-cost markets.
▶ Client metrics. Wipro added 1 client incrementally to US$100 mn bucket for a total of 9. Number of US$50 mn clients declined by 1 to 39 while number of US$20 mn clients increased by 2 to 93.
▶ New independent director. Wipro has appointed former SBI Chairman Arundhati Bhattacharya as an independent director for a period of 5 years, w.e.f. January 1, 2019.

Definitions of ratings

BUY	-	We expect this stock to deliver more than 15% returns over the next 12 months.
ADD	-	We expect this stock to deliver 5-15% returns over the next 12 months.
REDUCE	-	We expect this stock to deliver -5-+5% returns over the next 12 months.
SELL	-	We expect this stock to deliver

Our target prices are also on a 12-month horizon basis.

Other definitions

Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

Other ratings/identifiers

NR	=	Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
CS	=	Coverage Suspended. Kotak Securities has suspended coverage of this company.
NC	=	Not Covered. Kotak Securities does not cover this company.
RS	=	Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
NA	=	Not Available or Not Applicable. The information is not available for display or is not applicable.
NM	=	Not Meaningful. The information is not meaningful and is therefore excluded.

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