IT stocks are in favour for the same reason that consumer staples seem to be out of favour

Growth predictability arising out of adoption of digital technology has pushed up valuation of software companies  


Lately, who’s been leading digital transformation at your company? (a) CEO (b) CTO or (c) COVID-19?

This is a popular meme doing the rounds and we all know the answer. The spiked virus has driven an axe through the economy — Bloomberg economist Abhishek Gupta noted that in absolute terms, the estimated output loss would be $210 billion in Q1FY21 and $300 billion for the entire fiscal — but it has reshaped the way India Inc works. It has got corporate India working from home, rushing to get on the cloud and spending heavily on digital technology. A recent survey of Fortune 500 companies also indicated that nearly 75% of CEOs intend to accelerate technology transformation. This corporate makeover has cushioned the IT industry from the pandemic knockout.

Impressed with this resilience, investors — both retail and institutional — have flocked to the stocks. Vinay Paharia, fund manager, Union Mutual Fund, says that they are seeing promise in IT companies big and small (“across the capitalisation curve”) and are optimistic about the sector in the medium to long term. Atul Bhole, fund manager at DSP, says, “Under-ownership of IT sector and its relative attractiveness to other sectors given the environment has driven their stock performance in such volatile and challenging times.” The Nifty IT Index is up 34% in 2020 compared with the Nifty which is down 4%.

Timely transformation
If we rewind a bit, this sector has been doing well for a while now. In FY20, Indian IT-BPM industry (which includes IT services, engineering R&D, products and business process management) generated $191 billion in revenue (75% from exports). A Reliance Securities report from July 2020 noted, “…consumption of software/services as a percentage of GDP is on the rise.”

So, the trend towards digitisation was anyway gaining momentum when the pandemic struck and speeded things up. Sumit Pokharna, VP – fundamental research at Kotak Securities, says, “The acceleration in digital transformation programmes will lead to elevated growth for IT services.” This is evident in the deal wins in H1FY20, after the virus began to spread.

Infosys reported large deal signings to the tune of $1.7 billion, which is near the pre-COVID-19 quarterly run rate of $2 billion. The growth was led by its hi-tech vertical, which helps client companies become digital enterprises, with 13.4% YoY growth. Life sciences vertical grew by 7.7% YoY, and banking and financial services (BFS) by 2.1% YoY. What’s more, the company announced a multi-year contract with Vanguard worth $1.5 billion. Retail was the only vertical, which saw de-growth of about 7%. Large-cap peer TCS, too, reported deal wins worth $8.6 billion, in the latest quarter despite minor fall in year-on-year revenue.

Meanwhile, Larsen & Toubro Infotech (LTI) outperformed both its mid-cap basket as well as large-cap players. In Q4FY20, the company signed two large deals for $103 million. It followed it up with another large deal worth $20 million in BFS segment in the UK. Overall, it saw 19% rise in new deals in Q1FY21. Another mid-cap player that did well is Mphasis, which added 88 new clients in FY20.

All this exuberance has helped the companies offset de-growth in revenue from clients who are in highly impacted industries, such as travel and energy and utilities (EU). Infosys and LTI, along with Wipro and HCL Technologies, have highest exposure to the vertical with clients including BP and Chevron. While travel industry saw a washout, EU sector has been dealing with many structural challenges recently, such as a crack in crude prices, lower demand for oil and gas, and lower rig count (about 70% lower YTD).

Rushabh Shah, analyst, Equirus Securities, says that growth in the coming quarters would be driven primarily from financial services, hi-tech, telecom and life sciences and healthcare. Geographically, the European market has already started its recovery while the US is slowly picking up with its government’s proactive measures. Though, he adds, “Things need to get normal for spending to pick up as clients remain cautious.”

Besides the deal wins, fund managers say that they are impressed with the ability of IT firms’ execution and delivery capabilities, even during the lockdown (See: Hedged right). “I must say, distributed execution systems resorted by our top tier IT companies were made to handle such kind of shocks and have worked brilliantly in this need of hour with minimal disruptions to client business,” says Shridatta Bhandwaldar, fund manager, Canara Robeco Mutual Fund. Investors are also impressed by the companies’ strong balance sheet. “Our top-tier IT companies have illustrated razor-sharp focus on corporate governance standards, and always retained clean balance sheet structures, which help them in downturns,” mentions Bhandwaldar.  

In volatile times, investors look for better earnings visibility coupled with the comfort on balance sheet, free cash flow (FCF), return ratios and payouts. All of which are offered by quality IT stocks — beating consensus estimates — Infosys, Wipro, LTI and Mindtree, which witnessed sequential margin expansion in Q1FY21. The companies’ cost-cutting measures, such as wage-hike deferral, tight control on discretionary spends and lower travel costs, along with currency depreciation, were the key reasons for this margin improvement, according to an Motilal Oswal Securities report.

Jinesh Gopani, head of equity at Axis Mutual Fund, says that companies with a strong balance sheet will end up getting higher valuation as it increases their ability to do buybacks, give dividends, have strong cash flows and improving their return on equity every year. Gopani adds, “Companies that have the ability to survive, raise capital, grow and have stronger balance sheets will get much bigger. It is a scale game now, and will be very stock specific.” That is, big will get bigger.

Apurva Prasad, institutional research analyst – IT, HDFC Securities, echoes the sentiment. “In the near term, Tier-I IT should benefit disproportionately versus mid-tier,” says Prasad, adding, “As enterprises look to optimise budgets, consolidation of vendors will be a priority and Tier-I will have a slight upper hand.” With travel and visa restrictions, DSP’s Bhole sees, “large companies benefitting as clients opt for vendor consolidation to deal with fewer players.”

Large caps will also attract investors, with their well-diversified portfolio of clients and scale, with which they can deliver consistent growth every year. In contrast, the mid-cap growth trajectory tends to be more volatile owing to higher client concentration and lower margin profile. Over the past few years, mid-caps have broadly underperformed on revenue generation, margin performance or cash conversion, says Shah of Equirus. “This can be attributed to capability differentiation across verticals compared to Tier-I players, deep domain coverage coupled with inability to ramp up to newer digital technologies and more geo/vertical/client concentration, which could easily take a toll,” he adds.

Of course, mid-caps that have been taken over by private equity (PE) firms over the past few years have tended to do well, such as Mphasis, Hexaware and lately, Coforge. “They get strong business from the portfolio companies of the PE coupled with professional management and prudent capital allocation,” says Shah.

Staying on course

While the opportunities from this crisis are encouraging, there are challenges that cannot be overlooked. For example, as Paharia points out, companies need to continuously train themselves in new and emerging technologies, adapt to new models such as work from home, and manage attrition and new hurdles such as visa restrictions. Bhole adds that companies have to ceaselessly strive to stay relevant to their clients. “It is the biggest challenge with so many technology innovations and business model changes,” he says.

Kotak Securities’ Pokharna points out, even though there is optimism about spending reviving, the size of the investments is still not clear and there is always the possibility of second and third waves of the pandemic. Then there is US president Donald Trump’s increasing restrictions on H-1B visa issuance. Thankfully, Indian companies had seen this coming and have been localising their workforce over the years (See: Stitch in time). Companies including TCS, Infosys, Mindtree and HCL have 50%-60% local workforce currently.

Even with these concerns, market sentiment is positive because the sector is not trading at a deep discount to its fair value. Union Mutual Fund’s Paharia says that it is not a “bargain”. Instead, they classify it “as a growth sector within our investment process framework”. DSP’s Bhole, too, adds that for most of the companies, the resilient outlook has been adequately factored in. “But a few large companies can offer further valuation re-rating if they can deliver better growth with change in managements,” he says. Bhandwaldar believes relatively better earnings recovery is a possibility and that can drive valuations further in the next one to two years. He says the key variables to watch out for are — revenue performance, costs optimisation and pricing trajectory. And for now, some IT stocks seem to be ticking all those boxes.