Information Technology Sector Update - Hit Refresh - HDFC Securities

Mr. Apurva Prasad & Mr. Amit Chandra, Institutional Research Analyst, HDFC Securities

A sharp spike in demand trajectory (beyond resilience), significant operational improvement (at peak levels now), continuity in market share gains and industry tailwinds of accelerated DX has led to outperformance, with 58/37% gains/re-rating impact in IT index over 6M/12M period. We 'hit refresh' in this note and evaluate the relative quarterly trends across segments and demand/competitor indicators. Risk-reward is more favourable for tier-1s now and less secular across mid-tiers. Some macro risks such as second-wave/lockdown have increased, but that's likely to translate into a flattish demand curve instead of a double-dip.

Despite the broad spectrum of outcome/outlook globally, key trends in the sector are as follows: (1) Large deal pipeline is improving, despite strong bookings and slower decision cycles which is expected to pick-up by year-end. (2) Cloud-led strong deal bookings (Capgemini's bookings around hyper-scalers up 50%, IBM's cloud signings up 25%, Cognizant's digital bookings up 40% YTD). (3) Acceleration in vendor consolidation (up to 20% reduction in vendor count) driving deals with a focus on cost optimisation. (4) Shift to the cloud also resulting in delays in on-premise investments, but acceleration in large infrastructure modernisation deals (8 >USD 100mn GTS deals within 11 large deals for IBM) as enterprises upgrade their tech stack at the infrastructure as well as the application layer. (5) Continuity of positive momentum in BFSI, driven by digital/regulatory/cost in sync with increased tech spend, accelerated z15, increase in implementation go-lives, vendor consolidation and strength in retail banking, mortgage, capital market sub-segments.

Revenue outperformance: The strong sequential revenue performance was led by a reversal in supply-side factors, BFSI revenue growth outperforming by >300bps YoY, and strong growth in Retail & CPG and Life-science & Healthcare verticals. At the same time, E&U and Communications verticals lagged. In 2Q, tier-1 IT posted more robust sequential performance vs. mid-tier, as compared to a similar dent in 1Q. Revenue/APAT beat in 2QFY21 was 2.5/7.0%, and an increase in FY22/23E EPS averaged ~5%.

Margin outperformance continued in 2Q: gross margin led vs. SG&A led in 1Q: Margins have peaked in 2Q and are expected to moderate as wage hikes are rolled-out and some cost savings around Travel & S&M reverse partially over 2-4 quarters, even as offshore-mix is expected to remain high.

Outlook and valuations: We expect IT sector revenue growth (USD terms) at +0.5/11.0/9.5% over FY21/22/23E, translating into 12% APAT CAGR over FY20-23E (vs. 8% CAGR over FY15-20). We believe that the risk-reward profile for tier-1 IT (vs. mid-tier) is more favourable now, following strong outperformance of mid-tier in 3M/6M, higher macro risk translating into a flight to quality incrementally, tier-1 valuations at a discount to mid-tier and an upside potential similar to mid-tier (~15%). Maintain a constructive view on the sector. Preferred picks from Tier-1 include HCLT and INFY and mid-tier include Mphasis and Persistent.

Source : Equity Bulls

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