Technology - The IT industry post COVID - Truth v/s hype! - ICICI Securities

'Cloudification' and 'Digitalisation' had almost become synonymous with Covid. Expectations of a material and permanent increase in growth/profitability of the industry factor-in aggressive assumptions around (1) incremental monetizability of these technologies and (2) irreversible change in human behaviour. Prior hyper-disruptive events (e.g. Spanish Flu, SARS, demonetisation) and current mobility trends present a contrasting evidence. Hype aside, our analysis suggests Covid can at best drive ~150bs growth acceleration over FY22-FY23. If WFH is perpetuated, consensus expects material margin tailwinds. But, we believe otherwise given our concerns around possible proliferation of Talent as a Service model. For bottom-up investors, the sector presents interesting opportunities of growth/profitability improvement led by micro factors. Fair valuations should be at least ~40% higher (vs pre-Covid) as investors rethink discount rates, growth horizons and terminal growth. We reinitiate coverage with HCLT > Infosys > TCS and MTCL > LTI > MPHL as our top BUYs.

- Euphoria around cloud and digital needs a reality check! Incremental revenue/backlog trends of Azure/AWS over 1HCY20 suggest there is a huge disconnect between the hype and reality. Discounting the challenges on monetizability aspect, the headline increase in cloud/digital traffic over Feb-Jun'20 was extrapolated by consensus as a permanent increase in growth/profitability of Indian IT. Its core premise being stickiness in the digital channels led by an irreversible change in human behaviour. However, learning from prior hyper- disruptive events suggest 'most' of the behavioural changes will mean revert. Current mobility trends indicate that as economies recover and public transportation resumes, activity in physical channels is already reverting towards pre-Covid levels.

- WFH if perpetuated can be a margin headwind, not a tailwind. On the supply front, WFH's initial (and misleading?) success led to a couple of lofty expectations, viz. furthering offshorisation and margin accretion. One-off factors driving the initial success (e.g. fear of lay-offs) and simultaneous spike in fulfilment rates on crowdsourcing platforms (e.g. GitHub) make us skeptical! If adopted permanently, it can result in shift towards Talent as a Service (TaaS) model. While savings on adjacent costs (e.g. facility expenses) cannot move the needle much, industry can face headwinds on aspects like availability/cost of niche skill sets, productivity etc.

- How we think of post-Covid growth and margins: Our analysis suggests Covid can at best drive ~150bps pro-forma revenue growth acceleration over FY22-FY23. This should be led by enterprises catching up on their essential digital capabilities (e.g. end to end digital CX) as they strengthen their risk management/business continuity frameworks. Despite the multiple known unknowns (e.g. vaccine commercialisation) and sub-optimal economies, we expect pre-Covid growth to return by FY22. The proven business continuity (on sales and delivery) underpins this assumption. Other cost items taking their due course, limited travel and mix shift towards FPP will be the key margin drivers over FY20-FY22E.

- New normal for valuations?! More than the business, Covid will likely push up the valuations. Even before the pandemic, expanding multiples (e.g. TCS) continuously surprised the value conscious investors. This can be partly attributed to low interest rates, high liquidity and sharp deterioration in the Indian macro environment. As the sector successfully passed the acid test of Covid on business continuity, resilience and adaptability, a consequent valuation boost is understandable. As investors rethink the discount rates (-150bps), growth horizon (+5 years) and terminal growth (+100bps) assumptions, ~40% higher multiples should be the new normal as per our analysis. Potential increase in corporate taxes and/or tightening of banking regulations in US are key risks to the growth and margin trajectory of Indian IT.

Source : Equity Bulls

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