Indian IT Stocks Trading at 50% Discount to Their Fair Value and Global Peers: Edelweiss Research Report
As per a research report released by Edelweiss Securities on 2nd September, Indian IT stocks are trading at a 40%-60% discount to their fair value and global peers, and this anomaly in valuation is likely to correct over the next three-four years. Edelweiss analysts see a lot more headroom for Indian IT stocks over the next few quarters.
As of now, from January 2020 to August 2020, the Nifty IT index has already increased by 15.5% compared to over 5% decline in the benchmark Nifty50 index. Among Nifty IT companies, Mindtree has gained the most – higher by almost 50% year-to-date (YTD), followed by L&T Infotech, Infosys, Mphasis, and HCL Technologies. Since 23rd March, 26 stocks from the BSE IT index have more than doubled their prices (e.g., Tanla Solutions has increased by over 500%) and none of the stocks have given negative returns for the period.
The brokerage firm believes that the digital growth wave in India is building into a storm and is set to herald steep growth prospects for Indian IT companies.
Edelweiss analysts wrote in the report that "We believe the COVID-19 pandemic has accelerated the demand for hi-tech by shrinking the human activity into a world of apps—and in many ways efficiently so. The explosion in online activity has galvanised massive cloud-led adoption, digital adoption, and transformation of the core. Global digital penetration has been reset at lower levels in light of emerging realities, thereby resetting the high-growth phase for technology from FY24 to up to FY27 in the least.”
The report mentioned that structural cost savings from increasing adoption of work-from-anywhere (WFA) would also significantly help shore up the earnings of the companies. The report says, "Those structural cost savings from rising adoption of work-from-anywhere (WFA) on the back of reduction in travel cost, lower wages for talent in tier 3–4 towns, lower capital expenditure (capex) and resultant depreciation would follow are of no less significance and can power companies on their own standing—and our realistic optimism on the space."
Edelweiss Securities expects margins for the key companies in their coverage to improve by 250–350bps (basis points) over the next three years.
The report noted "Digital revenues and growth rates of Indian biggies such as TCS, Infosys, and HCL Technologies are superior to global peers such as EPAM and Luxoft; yet they are trading at 20–60% discounts to their fair value and a 50% discount to these global companies. This anomaly in valuation, we argue, would correct as the digital wave builds up into a storm over the next three-four years and would effect a seminal change in investor perception.”
The brokerage has raised the target price of Indian IT stocks under its coverage by up to 80%. From a purely returns perspective, they have pegged the order as follows: HCL Tech , Infosys TCS and Tech Mahindra among large-caps; Mindtree, L&T Technology Services and L&T Infotech in mid-caps; and eClerx, Cyient, and Persistent in the small-caps. (See Table 1 and Table 3).
The brokerage firm shared that its in-depth analysis implies a jump in earnings at a compound annual growth rate (CAGR) f 17%-19% over FY21-22–FY24-25 from 6%-12% over FY17-18–FY20-21, indicating an uptick of at least 1.5 times in trading multiples—similar to that for the FAANGs [(Facebook, Amazon, Apple, Netflix and Alphabet (formerly Google)] ecosystem. (See Table 21 and Chart 9).
The report says that "All in all, we strongly contend that a substantial re-rating driven by multiple earnings upgrades and higher price/earnings to growth (PEG) ratios—similar to what happened in FAANGs’ ecosystem—is in order.”
The firm agrees with the view that the global dislocation caused by COVID-19 will speed up consolidation towards larger players but denied that such consolidation would go against or hurt medium and small Indian technology players.
Edelweiss Securities believes that a stormy demand will substantially lift the Indian technology players across the board. The firm says that “Lags may be in order in some cases depending on respective companies’ exposure to sectors; hence, the ones acutely afflicted by the current pandemic would be the last ones to recover, but strongly nonetheless”. They have clarified that they do not have a negative view or ‘REDUCE’ on any stock in Indian IT, and that they strong believe that each company stands to gain from the powerful tailwinds that would continue to strengthen.
The brokerage also cautioned that there are a few key risks:
i) Serious data breach: The biggest risk to this digital-surge-driven thesis comes from any serious data breach at global tech companies primarily in the FAANGs ecosystem. Such events may significant bring down online web traffic and have a domino effect on technology spends owing to cautious traffic growth outlook. In fact, any major breach event could substantially reverse investments for a small period (say about two quarters).
ii) Adverse currency movement: USD depreciation vis-à-vis INR and adverse cross currency movements would modestly affect growth and earnings estimates of the Indian technology companies (refer to EPS/currency sensitivity Table 4).
iii) Budgetary allocations: A substantial cut in the US technology budgets, particularly in Digital, would mar the expected surge in growth at Indian IT companies.
iv) Regulations: Any adverse regulatory provisions and visa restrictions in key client markets may affect Indian IT companies’ capability to execute profitably.
Edelweiss Securities has also mentioned risks specific to companies (subject to their vertical exposure/mix) They are: i) bankruptcy of a large client; ii) delayed revival of the travel, transportation, hospitality and retail segments.
These findings are in-line with the Goldman Sachs research report on Indian IT companies, which came out earlier in August 2020.
Goldman Sachs had unveiled its report and stated that the current COVID-19 pandemic is expected to result in an increasing number of global technology roles finding their way to India as ‘work from anywhere’ becomes the new accepted norm.
According to the Goldman Sachs report, in the past also, major crisis have led to a sharp increase in outsourcing and even offshoring particularly to India. This is mainly on the back of lower wages for technology developers as compared to developed economies, and an increasing annual base of engineering graduates. The global brokerage firm anticipates that the top-5 Indian IT service-providers are expected to grow at about 12.6% (in average) in FY22 as compared to earlier estimate of 9.7%.
The report stated "Post Covid-19, we expect a third wave of outsourcing and an increasing number of technology roles globally finding their way to India as work from anywhere becomes the new accepted norm. With the most efficient supply chains, we believe India IT services companies are positioned favourably to benefit from a third wave of outsourcing after previous waves in 2000 (post Y2K) and in 2008-09 (post Global Financial Crisis)".
During FY16-17-FY18-19, the base of digitally skilled IT employees in India grew at a compounded annual growth rate (CAGR) of 37% to over 600,000, making India the hub and even the largest beneficiary under the ‘work from anywhere’ norm. The report added that “We believe these digitally trained employees at Indian IT firms are likely to drive overall revenue growth, which would be the key reason for their increasing relevance amid the requirement for digital-at-scale solutions”.
The report added that “We see TCS as one of the largest beneficiaries of these trends given its wide array of services/capabilities, geographic presence, wide client base, consistent strong execution and ability to work remotely at a large scale with 450K employees". TCS had announced a few months back that it plans to have 75% of its employees working from home permanently by 2025.
The report noted "This strategy, we believe would bring certain permanent cost advantages to the IT services firms around lower rental, facility expenses, including electricity, maintenance/repair and even lower capex around land/building required for extra seating arrangements. Some of these benefits though may be offset by additional capex for home IT infrastructure like desktops, more robust wireless/broadband networks and cyber-security tools."
The Goldman Sachs report said that while the labour and cost arbitrage model had helped the Indian IT industry in the first two waves of outsourcing, the industry seems to have now graduated to a value-based model “with a consultative approach around the best digital solutions on offer.” Some of the recent deal wins, where the providers are managing the entire IT function for the clients as part of large managed service contracts, and selling vertical-specialised solutions are examples of this maturity level. The report added “Both of the above approaches require more fixed-price and outcome-based contracts with higher risk-reward.”
According to KR Choksey brokerage, most IT services companies are likely to recover to some extent by the second quarter of FY20-21 as major countries emerge from lockdown and restart their economies. The firm stated “The criticality of technology to most firms’ operations across verticals, along with a further rise in digital and cloud spend post the pandemic, is likely to drive growth recovery from 2Q onward. However, the situation remains fluid and the pandemic is far from over; thus, recovery needs to be viewed with a hint of caution.”
The RBI has also echoed this sentiment in its annual report released in August 2020. The report mentioned “While companies may have put their IT expansion plans on hold and cut back their overall IT spends, there could be pockets of opportunity in software and related services for Indian IT due to an increase in demand and usage for certain IT-enabled services among the consumers and companies impacted by the pandemic”.
The fact that most brokerage firms are unanimous in their opinion that most of the IT services are expected to recover sooner or later is indicative of the resilience of the IT sector despite the fact that the current Covid pandemic has damaged the Indian economy severely.