Technology - Hype on the cloud, Reality on the ground! - ICICI Securities

We have earlier written in depth about the huge disconnect between hype and reality around accelerated cloudification / digitalisation post-Covid . Sep-20 earnings/outlook of global technology companies (Microsoft, AWS, SAP etc.) strongly corroborate our thesis. Rather than reporting a major spurt, incremental sales (QoQ) booked by AWS and Microsoft ICS (Azure++) post-Covid was weak (9MCY20: -24% to +5% YoY). This does not reconcile with the hype around cloud being the backbone for business continuity during the lockdown. Downgrade in commentary from cloud being a 'panacea' for Covid to a 'mixed bag' (e.g. by Amazon) was subtle yet steep! Gartner recently indicated that cloud 'scaled up' during Covid and 'scaled down' subsequently. Now it expects accelerated penetration through CY22 (rather than CY20). We anticipate a similar roll-forward of expectations from IT firms as well, with a lag. Accordingly, consensus' anticipation of a material improvement in their growth / profitability needs a reality check. Infosys / HCLT / TCS and Mphasis / Mindtree remain our TOP BUYs backed by bottom-up / company-specific investment rationale.

- The hype around accelerated cloudification / digitalisation. Right amid the pandemic, came the commentary of "10 years' magnitude of digital transformation / cloudification getting accelerated to just two months." Cloud was positioned as a panacea for all the Covid-led problems around business continuity / resilience. Our analysis of the qualitative commentary of global technology leaders over 1990-2020 indicate such hype is very much a part of evangelising / marketing a new technology proof point. However, this time, the hype became a key input for consensus' expectations around a significant improvement in growth/profitability of IT firms.

- Disconnect between the hype and reality. We acknowledge that as the base increases, growth rates could often be deceptive. However, had cloud adoption post Covid indeed seen a massive and sustainable increase, incremental cloud revenue / backlogs of AWS / M-ICS (Azure++) should have reported a material spurt over 9MCY20. Similarly, TCVs in 'As-A-Service' segment reported by deal advisories like ISG also should have witnessed a robust increase. However, no such trend has been noticed so far. On the contrary, incremental sales (QoQ) booked by AWS and M-ICS over 9MCY20 was weak at the best (-24% to +5% YoY). 'As-A-Service' TCVs reported by ISG were stagnant (link). To the extent time series data is available (e.g. SAP), current cloud backlogs have remained flat over the previous 3 quarters. An investigation into this divergence reveals interesting aspects around monetizability and adoption patterns across large/medium sized businesses during the pandemic (elaborated in detail in our note).

- Subtle, yet steep, downgrade on the qualitative outlook around cloud. While the commentary around cloud migrations was unconditionally upbeat 1-2 quarters ago, we are now noticing some level of caution and conditionality. As reality sinks in, this change was on our expected lines. For instance, amazon referred to cloud as a 'mixed bag' right now with a lot of clients showing a 'holding' pattern. Gartner recently indicated that cloud as a proof point 'scaled up' during the pandemic and 'scaled down' subsequently. It now sees cloud revenue shifting out of CY20 and expects accelerated penetration through CY22. Similar roll-forward of expectations from IT companies cannot be ruled out.

- Cloud/Digital - Evolution, not revolution! We do not dispute the evolution of cloud/digital as technology change takes its due course. However, contrary to consensus, we are sceptical on the prospect of Covid-led material acceleration of this technology change. Hype aside, we estimate at best ~150bps improvement in pro-forma growth rates of IT over FY22E-FY23E. This should be led by clients catching up on their essential digital capabilities/ risk management frameworks. More than the business, Covid will likely push up the valuations. As investors rethink the discount rates (-150bps), growth horizon (+5 years) and terminal growth (+100bps) assumptions, ~40% higher multiples in the new normal are understandable, as per our analysis.

Source : Equity Bulls

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