The Twin Dichotomy: Margin-Revenue
Expect polarized valuations to sustain
* Indian IT Services companies’ earnings estimates post 1QFY20 have been revised downward against the backdrop of continued supply crunch and its impact of profitability. However, some encouraging trends – sanguine demand and USD appreciation – have waded through the sporadic pockets of weakness, providing some comfort. That said, further weakening of global macros will likely mar steady growth momentum of IT companies, reversing the growth-margin dichotomy (from strong-growth-weak-margin to weak-growth-strong-margins).
* Historically, long-term valuation multiples of IT companies have had a correlation to bond yields and also to the INR/USD levels. However, the recent turn of global events have pushed the yields to an all-time low (1.48%) and led to appreciation of the USD v/s the INR, suggesting the coexistence of forces that may exert a pull on valuations in opposite directions.
* With growth rates receding but RoICs remaining well above the hurdle rates, capital allocation policies are being tweaked, with larger amounts of cash reserves being paid out to investors. This understandably makes IT companies sound defensive bets in volatile times, but contrasts the growth value that the industry enjoyed for the better part of the last decade and early part of this decade too.
* This trend parallels another one—the gradually growing valuation divergence between stable leaders and those playing catch-up. Valuation convergence of the likes of HCLT, TECHM WPRO to that of TCS and INFO has remained elusive, notwithstanding brief periods on company-specific factors. As on date, INFY, WIPRO, HCL and TECHM trade at a 20%, 74%, 62% and 18% discount to TCS.
* Against the backdrop of lower industry growth but healthy RoICs, cash return and supportive currency, it is logical to expect comfort in more predictable and stable companies within the sector compared to the higher-beta plays that may have a much higher upside on the thesis of a narrowing divergence. We expect valuation performance for companies such as TCS and INFO to match, if not better those of peers such as TECHM, HCLT and WPRO.
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