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Indian IT: raising the bar

We continue to maintain our positive outlook on the sector, following our relative optimism through last year (expanding centre of gravity: Aug’20, demand recovery in sight: Jun’20, built to last: Mar’20) and earlier. The bar is raised to positive unchartered territory with the classic bundling of (1) constructive market environment (cloudification, enterprise growth acceleration), (2) in-built and rising competitive advantage, and (3) superior execution (with an upside risk to operational performance). In this note, we examine key trends and growth prospects (top-down scenarios and long-term trends) and assess upside risk to the operating profile (margin sensitivity across key parameters).

The sector can trade at higher multiples, supported by meaningful acceleration (and improving visibility) in growth/profits, upside risk to margins as efficiencies are retained, better growth distribution across verticals ahead, strong and improving competitive advantage and lower macro risks. Our earnings estimates remain above consensus (5/7% higher for FY22/23E) on both revenue (~2.0/3.5% higher for FY22/23E) and margins, translating to an earnings CAGR of 16% over FY21-23E. The IT index is currently (at 26x 1-yr P/E) trading at a ~50% premium to its 15-year average of 17x; globally Accenture at ~70% premium to its historical multiples, and high growth midtiers such as EPAM/Globant at 1.5-2x TCS’ multiples

* Value migration to Indian IT: The sector’s competitive advantage continues to improve (~50% of incremental market share within global majors) and the pandemic has further unleashed sectoral tailwinds of a multi-year accelerated digitisation/cloudification. Tier-1 IT incremental revenue addition is set to double as compared to prior period addition, translating to a 12% CAGR in USD revenue over FY21-23E.

* Favourable denominator effect: Enterprise clients’ (n=96) growth is accelerating and 12% CAGR for Tier-1 IT implies 7pp growth premium over enterprise growth vs. prior period growth premium of 5pp.

* Broadening of vertical growth drivers and improving partner synergies: While BFSI vertical is expected to roll steady (rising tech spend-%), Manufacturing, E&U and Retail CPG are expected to accelerate (deal flow is up) and improve the distribution of growth (positive read-through for ER&D, HCLT). While synergies between hyperscalers/SaaS and Indian IT are improving, alignment via investments in sales/delivery is creating strong net new opportunities for the sector.

* Improving operational rigour and margin sensitivity: The cost of delivery has arguably peaked in FY20 and we expect the sector margins at 10-year average (margin outperformance from 3Q levels expected in TCS, LTTS, Mphasis, PSYS). The prospects of retaining the current elevated levels of offshoring are high and present an upside risk to margins (Mphasis/Mindtree). Our base case margin assumption factors 3/8% CAGR in onsite/offshore wage increase and we expect travel to revert to ~60% of pre-pandemic levels. Better throughput is expected based on higher utilisation and offshoring, favourable supply-side scenario (both onsite and offshore), and demand fulfilment factors (training, lower sub-con)

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