Wipro wrapped up a rather muddled fiscal 2018 with an average fourth-quarter performance. IT services revenue was within management’s prior guidance (accounting for foreign exchange movements) but was still at the low end of expectations. The quarter was notably impacted by two large client bankruptcies which counts for over $50 million in annualized revenue. In addition, Wipro’s healthcare business continues to see more clients leave the exchange market and the communications business saw ongoing weakness. In all, these issues have led management to warn of a loss in momentum for the upcoming first quarter of fiscal 2019.
However, it wasn’t all gloomy news with management seeing a return to growth for the business in the second quarter of the coming year. Continued strength in the high growth digital business and a well-supported book of business that is propped by recent deal wins will help to offset the headwinds.
For the quarter, gross revenue declined 1.6% year over year to Rs 137.7 billion. IT services revenue was flat year over year at Rs 134.1 billion 1.3%, although in U.S. dollar terms, IT services revenue grew 5.5% to $2.1 billion. Communications and healthcare were prominent industry laggards with both businesses posting revenue declines in the quarter. On a positive note, Wipro’s digital revenue grew 9% sequentially and now constitutes 26.7% of its total revenue. This digital business is expected to drive midterm growth, and with healthy digital bookings in the fourth quarter, we see continued momentum for Wipro’s digital investments.
- What is our investment thesis?
Wipro is India’s third-largest IT services exporter behind TCS and Infosys. We think Wipro will increase revenue in line with other Tier 1 Indian IT service vendors, given the firm's commitment to top-line growth. We believe its offshore mix and product relevance will appeal to organizations, given increasing budgetary pressures, time constraints, and internal IT quality concerns. In addition, the company's solid profitability, coupled with limited reinvestment needs and the spin-off of its non-IT businesses, is expected to drive strong free cash flow, which will support its growth.
Despite a highly competitive and rapidly changing marketplace, Wipro hasn't been shy in averting away from legacy services and we think Wipro's position in the IT services industry remains secure. The firm has a well-entrenched position in the market because of its significant global presence, industry expertise, proprietary intellectual property, and established client relationships. The company’s end-to-end service capabilities have led to some significant integrated deals and recent multiyear wins with clients that exemplify Wipro's service relevance and depth across varying industries.
- What is the company’s number-one priority?
Wipro’s number-one priority will be top-line growth.
The company will target investments that boost its geographic presence, vertical specialization, and productivity and platforms. Continental Europe continues to hold significant potential for Wipro, given outsourcing's infancy in the region and the market's increasing adoption of an outsourcing model. We think Germany is an area of particular focus for Wipro and believe management will look for inorganic growth opportunities in the country (Wipro's Cellent AG acquisition is a recent example). In a similar vein to Wipro’s development of its market-leading energy and utilities segment, we expect the company to supplement its organic growth in banking, insurance, healthcare, and manufacturing via acquisitions that broaden its scale and deepen its specialization (Wipro's HealthPlan Services acquisition is another good example here).
- What is the company’s economic moat?
High switching costs underlie Wipro's narrow economic moat.
The company has decades of industry experience and a trove of loyal customers that rely on the firm to provide mission-critical business processes and IT services. Such mission-critical services allow for a deep understanding of clients' intricacies, and as a result, customers are reluctant to switch between vendors, as it could cause significant business disruption.
Notably, Wipro's revenue from repeat business traditionally hovers around 97%-99%, supporting our view that the firm benefits from high switching costs. The firm's broad global delivery capabilities, combined with its ability to offer myriad integrated services (such as BPO services, application services, and infrastructure services), set it apart from smaller rivals and help the company attract marquee global clients. In fact, Wipro has more than 1,300 global clients, of which 150 are Fortune 500 companies.
- What is the company’s fair value estimate?
After rolling our model forward one year and tempering our short-term growth outlook, we maintain our Rs 325 fair value estimate.
Our updated financial model implies forward fiscal-year price/earnings of 17 times, enterprise value/adjusted EBITDA of 12 times, and a free cash flow yield of 6%. We expect Wipro to increase its revenue around 7.3% per year (in Indian rupee terms) over the next five years as it remains focused on top-line growth. We think the firm will supplement its organic growth in core markets such as energy, finance, manufacturing, and healthcare with acquisitions that enhance its industry expertise, skill sets, and global presence. In terms of geographies, the European market is an obvious growth opportunity for Wipro, given the region's increasing willingness to adopt an outsourcing business model and an underpenetrated marketplace. We believe the firm will seek to increase its presence in Europe, and we expect it to use mergers and acquisitions to achieve this. We forecast a modest improvement in operating margins over the next five years (an approximate 150 basis-point improvement) after heightened reinvestment and restructuring abates. Greater focus on automation, process simplification, workforce utilization, and better acquisition integration is expected to help counter yearly wage inflation and reinvestment requirements too.
- Is it a good time to buy?
The FVE is Rs 325. Yesterday, on April 25, the shares closed on the BSE at Rs 287 and touched a high of Rs 293.95.
With shares close to our fair value estimate, we’d seek a wider margin of safety before investing in the name.
Consider buying at Rs 195 and consider selling at Rs 503.75.
- What is the company’s stewardship rating?
We rate Wipro’s equity stewardship as Standard.
Chairman Azim Premji, who is widely regarded as one of the most influential business leaders in the world, has led Wipro since the late 1960s. Premji holds approximately 75% of the company's outstanding shares. Despite his large controlling stake, we think his shareholder-friendly record should hearten investors. Premji has received numerous accolades for his ethical and fair business practices and commitment to societal issues, such as public education.
Abidali Z. Neemuchwala, who is seen as a visionary around as-a-service products and services that should help Wipro adjust to the transforming digital IT services market. With his extensive experience in the industry, we think Neemuchwala is an appropriate leader for Wipro, despite short-term client-specific and macroeconomic factors weighing on his early tenure.
Acquisitions will continue to play an important role for Wipro as management looks to further develop its domain expertise, geographic presence, and global delivery capabilities. In the past three years Wipro completed several acquisitions (approximately INR 72 billion has been spent) in global oil and gas information technology, mortgage due diligence, and risk management services. Management has an internal margin band that it aims to maintain (the operating margin has usually hovered around 18%-20%). Still, Wipro has highlighted some key areas where it will not cut back on investment, such as sales and marketing, consulting, and IP development associated with process automation.
- What are the risks we see?
The IT services industry is highly competitive and constantly changing. Wipro needs to continually reinvest in new innovative service offerings in order to remain relevant in the marketplace. Employee attrition and utilization are also metrics that need to be managed closely, as these measures can have a notable impact on the firm's operating performance. Any detrimental change to U.S. immigration law could inflate the cost of Wipro's global delivery model, given the company's use of visas such as the H-1B. Meanwhile, a large appreciation in the rupee against the U.S. dollar would have a negative impact on Wipro's cost base. Also, negative movements in GDP and global IT spending would have a detrimental effect on the company.
