Information Technology : Sector Update - HDFC Securities

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

In this note, we 'hit refresh', evaluating IT sector's performance in the quarter gone by as well as reviewing the outlook. Over the past year, IT index' re-rating (16x to 23x) and performance (>90%) have been supported by the increase in consensus earnings estimate of 20/30% for tier-1/mid-tier. FY21 closed with low single-digit revenue growth, 8/20% profit growth (tier-1/mid-tier), and an astounding 35/55% growth in OCF/FCF. The pandemic has not just accelerated digitisation but has quite evidently sharpened the operational engine (beyond the transient factors).

Key lead indicators remain strong with tier-1 IT deal TCV of USD 16.8bn in 4Q (book-to-bill ~106% which doesn't include all renewals), recovery in consulting (record bookings for Accenture and Booz Allen), slight improvement in deal market-share by TCS/INFY vs. global majors, and supply-side commentary from large global staffing. The flipside, however, is the slight moderation witnessed in the overall deal bookings (2% YoY in 4Q compared to 10% for FY21). The more apparent near-term challenge is supply-side impact in India and rising attrition, but we believe on anecdotal evidence that attrition has peaked and the taper will reflect with a lag from 3Q. In the interim, the supply-side crunch for highly-skilled talent (not a homogenous feature) will discourage price aggression in large deals.

Key growth drivers for the sector include: (1) strength in BFSI vertical supported by continued growth in tech spend, mainframe performance, and strong pipeline/bookings led by system rationalisation/digital transformation; (2) recovery in ER&D segment based on macro recovery in US/Europe, strong industry outlook by the largest provider (Capgemini engineering deal pipeline by volume up over 50% QoQ), and uptick in manufacturing vertical with continuity in strong deal volumes; and (3) investments and alignment with partners including hyperscalers/SaaS.

Key hits & misses: IT sector performance was largely in line (-0.1/0.8% variance in aggregate revenue/APAT), but the details get more interesting. While mid-tier growth outpaced tier-1 IT, tier-1 IT outperformance was led by TCS/WPRO in revenue and INFY in margins (underperformed on revenue though). Mid-tier IT had stronger pockets of outperformance, led by TELX, CYL, MAST, SSOF with the top scorers posting almost double-digit sequential growth. The impact of the wage hike was offset by continued increase in offshore-mix and operating leverage (volume/utilisation). The earnings upgrade over the past three months has been led by PSYS, TELX, MTCL, and CYL in mid to high single digit and concurrently >30% stock performance.

Outlook and valuations:. Following 10% earnings growth in FY21, we expect the sector to deliver 15% CAGR as revenue accelerates to 15% in FY22E and then normalises to 11% in FY23E. In the context of reducing earnings growth premium vs. tier-1 IT, we recommend some toning down in the midcap IT exuberance with (1) lower margin of safety following a 3x surge, (2) valuations at ~30% premium to Tier-1 (3Y average at 5% discount and peak at ~35% premium in Aug'18), and (3) greater margin susceptibility to supply-side related cost of delivery mechanics. Downgrade TELX and PSYS to ADD (BUY earlier). Remain constructive on the sector and preferred picks include Infosys, HCLT, Mphasis, LTI and Sonata.

Source : Equity Bulls

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