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Can offshore techs go back to trading at premium to global peers?

The strong upward price action in Indian techs in the past couple of months has baffled even the diehard Bulls on offshore techs. Stocks are trading at significantly higher multiples than 5 year means (in some cases higher than 5 year Mean+ 3 S.D. as well!).

So what explains this?

While the street (including us) has written extensively about the likely growth acceleration in tech spending ( and increased acceptance around offshore delivery) post the Covid-19 crisis, we believe that the sector may regain its premium to global peers (as it used to pre-GFC) as revenue growth continues to be higher than recent years supported by relatively stable margins ( ex-currency) in our view despite the stiff supply side challenges supported by pricing leverage (once again in a position of strength after multiple years, refer links here and here).

Commentary from some industry players in recent past continues to provide confidence in a longer run way on growth acceleration (beyond FY22 as well!) with 2QFY22 earnings season expected to provide further evidence on that front in our view.

* Offshore techs have traded at premium to Global techs in the past:

Indian techs like Infosys and TCS used to trade at premium to global techs like Accenture (Unrated) in the past (refer exhibit below) with Infosys trading at a premium to Accenture until 2012/2013 and TCS trading at a premium to Accenture until 2016/17. The valuation premium enjoyed by Indian techs came off over the recent years with Accenture trading at premium to both INFO and TCS. This dynamic was driven by the fact that growth rates for Indian techs were in a declining trajectory along with a slow down-drift in operating margins.

On the contrary, Accenture’s outsourcing revenue growth was holding much better and its overall operating margins were also holding up much better aided by the increasing mix of Outsourcing revenues along with the benefit of greater Global delivery footprint. The moderation in growth for Indian IT was also resulting from their higher dependence on the legacy stream. Digital percentage of revenues has increased to ~50% of revenues for Indian techs as well now and should aid in terms of both blended growth as well as margins.

* Covid has upended overall growth (and offshore shift!):

The Covid-19 crisis has led to an acceleration in digital transformation agenda for global businesses and further reaffirmed the value of the Global Delivery model. This is reflecting in the strong revenue growth rebound being seen nearly across the board and companies stepping up hiring in recent times (note that we expect the TWITCH group to exceed the prior net hiring high recorded in FY12!).

The commentary from the industry players in recent past seems to suggest that the revenue growth momentum could sustain over the next 2-3 years at the least. (for e.g. US listed global peers like Globant already suggesting upsides to medium term growth aspiration of 20% YoY growth for CY22/FY23). Strong revenue growth coupled with higher offshore shift is also driving some pricing leverage for the companies (after several years) even as we continue to hear about emerging supply side constraints as well. The other dynamic that is favoring offshore techs is that Digital business now accounts for ~50% of revenues for them and thereby aiding in terms of both company wide growth and margins.

* Valuations for Offshore techs on the way to convergence with Accenture again : The valuation multiples for Indian techs have seen significant uplift in the past 12 months as the underlying dynamics yet again favour Indian offshore techs. Even though valuations appear at significant premium to 5 year mean multiples, the valuation re-rating is supported by improving growth trajectory (relative to prior years, supported by increased tech spending, greater confidence in offshore delivery and increased mix of digital business for offshore techs now).

We continue to believe that the sector is heading into a phase seen through 2004-07 when it enjoyed both volume and pricing leverage with companies being able to defend/manage margins despite the supply side constraints led by growth leverage. We reckon 2QFY22 earnings season to provide further confidence on sustained revenue growth over the near/medium term.

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