Apurva Prasad, Institutional Research Analyst, HDFC Securities and Amit Chandra, Institutional Research Analyst, HDFC Securities.
In this note, we decode the signal from noise and probe some key questions: (1) How structural is the demand and how correlated is it to the macros (top-down assessment)? (2) Can the inflationary pressure on enterprises accelerate tech spend (enterprise trends - growth vectors)? (3) What's leading to growth visibility beyond CY22 (cloud partnerships-the second order impact)? (4) What led to the multiple reset and what's in the price (mean reversion 'favourable' outcome). We believe that there's high probability of double-digit growth outcome in the medium term and the structural drivers more than offset any macro variability. Risk-reward is favourable for tier-1 IT as current valuations imply a modest growth ask-rate; at the same time, mid-tier IT will sustain its growth premium. We have a constructive stance on the sector and our top picks are Infosys from tier-1 IT and Persistent Systems from mid-tier IT, both of which reflect growth leadership.
Top-down assessment: Despite the correlation to the macro, the demand for the sector is structural (double-digit CAGR over five years is high probability). For mid-tier IT, growth premium is highly correlated to macros; for tier-1 IT, growth is a greater function of market share gains, compared to industry growth. Inflationary pressure on enterprise can accelerate technology spending and some key drivers include: (1) inflationary environment and constrained supply/talent market improving the value proposition of third-party service providers (gap between job openings & unemployment); (2) increased outsourcing from Continental Europe (~25% increase in deal volumes) and increase in travel/onsite releasing some pent-up demand; and (3) lower down-spiral impact of pricing in legacy services.
Enterprise trends-growth vectors: Enterprise tech spends are strong and there's limited impact on overall growth due to any vertical-specific slowdown. Key insights: (1) while Q3-Q4 enterprise growth trajectory is moderating, growth ahead is still expected to be above long-term average; (2) growth delta-E&U, travel & hospitality verticals; and (3) strong tech spend continuity in BFSI. Tightening macro conditions are likely to lead to increasing investments in digitisation to reduce cost of operations and tech budgets are expected to increase in CY23, driven by modernising of the application portfolio.
Cloud partnerships-the second order impact: Tech value migration towards cloud providers is underway and will drive the growth curve of SIs. Our partnership framework and industry checks suggest that (1) partner ecosystem is expected to be the key driver of growth with hyperscalers becoming key deal influencers, (2) hyperscalers are valuing SI partnership diversity (positive for midtiers), (3) several mid-tiers are gaining disproportionately in the cloud ecosystem of AWS (LTI, MPHL), Salesforce (PSYS, MTCL) and mid-tier potency is supported by (a) accelerated shorter duration deal activity and better bandwidth by mid-tier IT in USD 10mn deals, and (b) increased digitisation in the mid-market segment.
Mean reversion 'favourable' outcome: The recent divergence between earnings trajectory and P/E de-rating is at a historic high, with the sector P/E de-rating by 35%, from 35x to 22x YTD. We believe that the tier-1s have higher margin of safety on our base case intrinsic value and assess stress impact on earnings (based on prior drawdown in earnings estimate). Current valuation implies ~6.5% CAGR in USD revenue over FY22-32E for tier-1 and 12.5% CAGR in USD revenue for midtier IT vs. historical trajectory of 8% CAGR and 12.5% CAGR respectively (askrate of growth is modest with 2-5 years of structural groundswell). The cut in multiples are reflecting the seismic denominator effect of higher cost of capital and front-ended cross currency impact; BUY/ADD on this dip.