Indian IT: expanding centre of gravity
We maintain our positive outlook on the sector despite the sector recently re-rating to +2-SD valuations. The centre of gravity is expanding beyond just the tier-1s, as mid-tiers are showing symmetry in balance sheet metrics (and reverting to growth premium). Core strengths across the sector include (1) low cyclicality supported by high-annuity/client longevity, diversified industry verticals, growth drivers across cycles and large TAM and (2) strong cash generation and capital allocation. In this note, we have assessed the sector's capital allocation and used multiple scenarios (growth-time, payout, and work-from-home or WFH) to deconstruct value.
We believe that the sector is poised for higher multiples, led by (1) the longevity of high-growth period (current valuations imply ~5% 10-year CAGR) with ‘multi-year’ growth tailwind from the economic crisis, (2) the continuity of high (increasing) payouts, and (3) global ‘best in class metrics’ across growth, free cash generation, and balance sheet strength. We reckon that the sector (including mid-tier) can command multiples higher than historical averages, supported by the sector’s resilience and growth longevity (in some cases anti-fragility).
- P/E multiple expansion drivers in place—growth longevity, higher payout, WFH: Key inferences from the two-stage DDM for the sector and payout and WFH sensitivity on return ratios are: (1) multiples can expand from 19.5x to 23x if the high-growth period extends from five years to ten, (2) multiples can expand from 18x to 20.5x with payout increasing from 50% to 100% for a 5-year high growth of 10%, (3) TCS’ performance will be RoE accretive at >2.2% growth with 90% payout, and INFY’s performance will be RoE accretive at >4.5% growth with 85% payout, at ceteris paribus. Also, the sensitivity to lower Capex will be RoE accretive by 235bps over FY20-23E, assuming WFH at 50% and 5% revenue growth for TCS, and accretive by 360bps, assuming 75% WFH.
- The anatomy of value—strong pedigree vs. global peers: Indian IT has a strong pedigree, which is reflected in its global ‘best-in-class’ metrics of capital allocation, balance sheet strength & efficiency and lower capital requirements. These are premised on (1) lower Capex and acquisition intensity (yet higher growth) than global peers, (2) strong payout/FCF and higher cash position, (3) higher asset turns and lower risk from intangibles and goodwill impairment.
* Demand drivers in place: Key highlights from MD&A assessment include the following: (1) demand is expected to increase for services around digital channels, collaboration and workplace transformation, (2) pipeline is expanding in areas of cloud, workplace transformation, cost efficiency and automation, (3) companies have adopted remote management of upstream processes such as solutioning, requirements workshop and service transitions are done virtually without impact on productivity, leading to on track contractual commitments and go-live dates.
* The upside case: Despite the recent re-rating in the sector (one-year fwd reached +2SD), reverse DCF based on current price implies: (1) TCS/INFY growth at 6.9/6.7% over FY23-30 and HCLT/WPRO/TECHM growth at a modest 5.1%/4.4%/5.8% and (2) Mphasis appears most attractive with implied growth of -0.6% over FY23-30. PSYS and TELX are candidates for a higher payout, based on the disconnect between current efficiencies and high cash. Upgrades include TCS (ADD), Persistent Systems (ADD) and Cyient (ADD).
* Top Picks: INFY, HCLT, LTI, MPHL and SSOF
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