Acceleration in technology spend at top BFSI firms
Remain buoyant, also aided by certain one-time increases in spends
* As we anticipated in an earlier edition of this note (link), technology spending at the top global BFSI firms indeed surprised in 2QCY20.
* Growth in aggregate technology spend in the 5 key US banks – JPM, Citi, BofA, MS, and Bancorp – accelerated to 7% YoY in Jun’20 (v/s 5% in Mar’20).
* Barring Citi, spending growth trends at other 4 banks were robust (9–14%, YoY).
* Compared with 1QCY20, growth (YoY decline) in technology spend accelerated (moderated) across most of the key European BFSI firms (e.g., Credit Suisse, UBS, and Banco Santander). Adjusted for one-offs and non-cash items, while technology spend at DB remained stable, that at Barclays declined.
* For numerous enterprises globally (including BFSI), tech spending decisions over Mar–Jun’20 were largely reactive, rather than proactive.
* In the wake of the COVID-19, firms were compelled to incur certain one-time spends to ensure business continuity. These included the purchase of hardware, software licenses and cloud migrations for remote work access etc.
* Similarly, as global banks struggled to cope up with the herculean task of distributing stimulus funds within a short time frame, we understand a number of them had to make one-time investments toward reconfiguring their systems.
* These spends were one-time events and are unlikely to recur going forward.
However, accelerated digitalization looks like more of a secular trend
* Not surprisingly, almost all of the banks hinted at a phenomenal increase in customer engagement through digital channels, driven by lockdowns.
* We postulated that this increase in digital engagement, led by a lack of choice, should eventually result in permanent change in customer behavior.
* Commentary of global banks in 2QCY20 has reinforced this argument. Even as economies re-open and social distancing protocols are relaxed, global banks expect digital adoption by customers to remain sticky.
* Accordingly, most of them outlined plans to turn more tech-driven and efficient. This is also viewed as a way to optimize cost related to the physical channel. Some BFSI firms (e.g., Barclays) made an explicit reference to the fact that digital channels are able to offer engagement with clients while simultaneously securing superior margins (v/s branches).
* Some key technology themes echoed in the earnings calls of the global banks: (a) accelerating the shift to digital, (b) cloud migration, (c) automation, and (d) reshaping physical and branch presence.
Yet to reflect in BFSI revenues of Indian IT companies
* Over the previous 9 quarters (post the segmental reclassification by TCS and Infosys), aggregate BFSI revenue of Top 7 IT companies (includes ACN & CTSH) closely tracked the aggregate technology spends at the Top 8 global banks.
* This correlation is understandable given that the Top 8 global BFSI firms account for a significant share of the aggregate IT spend by the BFSI vertical. Similarly, the Top 7 IT vendors account for the lion’s share of their outsourcing ecosystem.
* However, the correlation seems to have discontinued this time. Even as aggregate tech spends at the Top 8 banks grew 3% YoY, the aggregate revenue of the Top 7 IT companies from BFSI declined 4% YoY (USD). This divergence looks sharper (~11 pp) if only Top-5 US banks are considered for this analysis.
* Barring Infosys (-2% YoY, organic) and TechM (19% YoY), all other companies reported sharp declines in BFSI revenue (USD). Robust growth at TechM was largely led by a favorable base and ramp-up in an APAC-centric insurance deal.
Is this divergence led by loss of wallet share to captives?
* The weakness in BFSI revenue of IT companies seems to be more pronounced in Europe. This is partly attributable to the fact that Europe’s BFSI industry was relatively late in giving compliance approvals and migrating to the remote work model. Notably, the US BFSI industry itself reacted late in this regard.
* Accordingly, we reckon India’s IT industry was disadvantaged on the supply side for at least a month (i.e. April-20) within this vertical. A significant share of spend during this time could have been executed through internal IT teams/captives, where compliance approvals were obtained relatively early.
* Moreover, we understand that exposure to niche sub-segments (e.g., Cards / Payments), which are entwined with heavily troubled verticals, would have shaved off some percentage points of growth for Indian IT companies.
* In conclusion, we are of the view that this aberration is likely to be a one-off, driven by: (1) spends in areas where IT companies do not participate, (2) supplyside bottlenecks v/s captives in April, and (3) exposure to certain niche subsegments. It is unlikely that India’s IT industry is losing wallet share to captives.
* On the contrary, some IT companies (such as Infosys and HCLT) indicated they were benefitting from the consolidation opportunity and gaining share from tail vendors.Our primary research corroborates this trend.
* As proactive decision-making returns and one-offs are behind, the BFSI revenue of IT companies is likely to again echo the strong and secular technology spending trends at global banks.
* Given the above themes, BFSI vertical should be a key driver of medium-term growth for Indian IT and accordingly we expect companies with high BFSI exposure to be major beneficiaries (e.g. TCS, INFO, WPRO, LTI, NIIT, MPHL)
Valuation and view – Remain positive on the sector, but wary of risks
* In the last month, the Nifty IT rallied 18% (v/s 4% rally in the Nifty), led by the strong surprise on cost and cash management by the sector in 1QFY21.
* Despite the COVID-19 disruption, IT saw limited impact on revenue, strong deal signings, and the closure of certain marquee deals (e.g., Vanguard – Infosys and Ericsson – HCLT). This led the street to rethink the resilience, adaptability, and terminal growth rates of the business model. In conjunction with the fall in riskfree rates, the sector witnessed decent multiple re-ratings across the board.
* As more of the physical economy migrates to the Digital space, Indian IT would be the key second-order beneficiary, in our view. Accordingly, we believe this rerating was due. Despite the strong rally, we continue to prefer IINFO, TCS, HCLT, and WPRO among the large-caps and LTI, MTCL, and PSYS among the mid-caps.
* In this context, some of the promising low P/E stocks (such as HCLT, WPRO, TECHM, PSYS, MPHL & CYL) outperforming the Nifty IT would not surprise us.
* (1) Potential demand, pricing, and WC headwinds post the withdrawal of stimulus (even in FY22) and (2) political uncertainty in the US around corporate taxes in the wake of an impending election are key risks to moni
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