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A wake up call against unrealistic expectations!

Our anti-consensus sector stance that steady state growth/margins are unlikely to be higher vs pre-covid (Link, Link, Link) echoed in Q4FY21 performance/outlook. As consensus rationalised lofty expectations to an extent, sector witnessed downgrades - notwithstanding the sharp INR depreciation. Despite the continued euphoria, incremental cloud sales at hyper-scalars remained range bound. The sector continued reporting strong deal wins.

However, this metric per se is noticed to be incomplete with no strong causal relationship on future growth. In FY21, BFS / Healthcare witnessed ‘reactive’ (to covid crisis) spends. (1) Rebalancing of these spends in FY22 and (2) geographic de-risking by clients pose key risks to outlook. (1) Resumption of office/marketing events onsite, (2) increase in onsite effort, (3) employee absenteeism in India, (4) catch-up investments and (5) acquisitions should translate into largely pre-covid (or lower) margins.

Multiples remain significantly higher (NIFTY IT: +41%, vs pre-covid averages) on absolute and even relative basis (NIFTY: +19%, BANK NIFTY: -8%, NIFTY FMCG: +3% and NIFTY Pharma: +24%). More overheated in case of mid-cap IT. Valuation premia are still banking on ‘post covid growth acceleration (g)’ expectations implying further scope for disappointments. Rising rates (r) should pose additional risk to multiples as (r-g) spreads widen. We maintain our anti-consensus cautious stance on sector.

* Mar-21 a wake-up call against unrealistic expectations.

Robust ‘recovery’ over H2CY20 from the covid dip has often been extrapolated as long-term ‘growth’ by the street. In absence of proportionate strength in the lead indicators, we have been cautioning against such extrapolation (Link, Link, Link). Mar-21 results are a wake-up call in this regard. Adjusted for a bit of a base shift, organic growth of most companies reverted to their long-term March averages (See ‘Narrative in Charts’). Aggregate revenue of tier-I IT in most verticals (e.g. retail, manufacturing) is more or less at pre-covid levels (Dec-19). Notable exceptions being BFSI (+11%) and Healthcare (+17%) – which can be largely attributed to ad-hoc covid reactive spends (e.g. contact tracing apps, pay check apps etc.).

* Softer-than-expected outlook in most cases.

In FY21, majority of companies either reported revenue decline or low growth. Given the favourable base, good deal booking and captive takeovers many companies reported through FY21, double digit / midteen growth for FY22 became a base case expectation. Even with this anticipation, it should be noted, the normalised CAGR over FY20-22E would be in mid / high single digits – lower or at par with pre-covid growth rates. Explicitly or subtly, the sector toned down the growth outlook (vs a quarter ago) with the exception of a few firms (e.g. WPRO, LTI, Mindtree, Coforge). In addition, a disappointing March growth run-rate further reinforces our argument that steady state growth (FY23 and beyond) is unlikely to be higher than pre-covid levels. As consensus rationalised lofty expectations to some extent, the sector witnessed earnings downgrades despite a strong tailwind from the exchange rate reset (from 73 to 76).

Optimists on the sector seem to be taking comfort from the strong deal wins reported during Mar-20. However, going by the previous trends (See ‘Narrative in Charts’), this headline metric in itself doesn’t appear to be a very credible lead indicator for revenue growth. Without further granularity on the (1) mix of new – renewals – restructured deals, (2) duration of execution and (3) extent of roll off in the portfolio of deals under execution, this metric is incomplete, in our view. Knowledge of large deal ramp up can, at best, help in predicting a potential near-term spike in revenue.

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