Edelweiss Wealth Research IT - Growing from strength to strength
Debashish Mazumdar Research Analyst [email protected] Date: January 8, 2021
Index
Table of Contents Page No. Story in a nut shell ...... 2 Valuation comparison ...... 4 Indian IT Sector: Growing stronger through multiple cycles ...... 5 Digital and Cloud to drive growth; Pandemic to accentuate adoption rate ...... 10 Indian companies are transforming to ride Digital and Cloud wave ...... 15 Initial round of investment over; Work from Anywhere (WFA) to benefit margins ...... 19 Valuation seems expensive optically, Earnings growth to drive stock performance ...... 24
Company Section
Infosys ...... 34 HCL Tech ...... 36 L&T Infotech ...... 38 Mindtree ...... 40
Indian IT Services Growing from strength to strength
Indian IT sector: Growing stronger through multiple cycles Debashish Mazumdar Story in a nutshell Research Analyst Major crises have historically been a boon for the Indian IT industry. During trying [email protected] times, domestic IT companies have witnessed increased offshoring and outsourcing. The companies too have risen to the challenge – ascending the maturity curve and Infosys Ltd providing cost effective and efficient solutions to the changing needs of global CMP: INR 1,260 clients. The fortitude of Indian IT firms can be gauged from their ability to Target price: INR 1,700 successfully ride multiple technology waves with manifold growth – from USD8bn Upside: 35% in FY00 to USD191bn in FY20. Despite being labelled a labour-arbitrage industry, Rating: Tactical BUY Indian IT companies have (a) delivered higher margins (v/s the best global tech companies) along with healthy free cash flows, and (b) gained market share in the HCL Tech largely fragmented global IT services sector. CMP: INR 960 Target price: INR 1,500 Digital and Cloud to drive growth; Pandemic to accentuate adoption rate Upside: 56% The Covid-19 outbreak has forced businesses globally to recalibrate their business Rating: Tactical BUY models to the changing customer landscape. The pandemic has unleashed exponential use of technologies, and thus, has been advantageous for tech players, L&T Infotech especially Cloud providers. With technology emerging as the fundamental bedrock CMP: INR 3880 for growth, global Digital IT services spending is estimated to reach USD900bn (at Target price: INR 4500 16.5% CAGR) by FY25E from USD490bn currently. Upside: 16% Rating: Tactical BUY Indian companies transforming to ride Digital and Cloud wave Cloud and Digital are in a stage where technology has largely matured with Mindtree standardized solutions (it can be customized based on business requirements). CMP: INR 1680 Further, Indian IT companies have significantly increased their presence in the new Target price: INR 2100 Upside: 25% Digital world by (a) acquiring capabilities through small company acquisitions, (b) Rating: Tactical BUY reskilling employees, and (c) signing large transformational deals with Fortune 500 companies. Digital now contributes 30%+ to the IT sector’s revenue and is growing at ~30% annually.
Initial round of investments over; Work from Anywhere (WFA) to benefit margins
Over the last few years, margin performance of Indian IT was hampered due to the initial investments required to penetrate Digital/Cloud space. However, Digital business has now reached a healthy size. Also, the Covid-19 pandemic has engineered a structural shift – it will not only save costs for clients but will also be margin accretive for service providers. The sector has witnessed strong margin expansion recently, which we believe is sustainable on account of lower (a) subcontracting cost, (b) attrition, and (c) SG&A spending.
Valuation seems expensive optically; Earnings growth to drive stock performance
The IT index meaningfully outperformed the broader market index since the Covid- 19 lows made in March 2020. While the sector’s valuation seems rich, it should not be viewed in isolation. Various aspects such as the macro environment, technology cycle, and earnings expectations should be factored in. We believe FY22-23E will be another watershed moment for the Indian IT sector with companies witnessing healthy growth and margin expansion.
Top large-cap picks: Infosys (INFO) followed by HCL Tech (HCLT).
Top mid-cap picks: L&T Infotech (LTI) and Mindtree (MTL).
Date: January 8, 2020
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Indian IT Services Growing from strength to strength
Story in a nutshell Indian IT sector grown multi-fold over last two decades.. … and reported higher profitability among global peers 26% 25% 22% 18% 14% 15% 16% 16% 15% 44 11%
34 ($ Bn) ($ 147 24 98
3 TCS 10 50 IBM EPAM 5 18 Wipro Infosys Tech HCL Tech HCL Mahindra Cognizant
FY00 FY05 FY10 FY15 FY20 Accenture Capgemini
IT Export IT Domestic Latest Quarter EBIT
New technologies to drive IT spending going forward Indian Tech already significantly penetrated into the digital world…
Mindtree 39%
LTI 41%
Wipro 41%
HCL Tech 19%
Infosys 42%
TCS** 31%
Digital as % of Revenue as on Q4FY20
Reskilled employees aid in digital penetration Aggressive acquisition strategy helped in obtaining new capabilities 1.00 25% 20 3,000 2,614 2,500 0.80 20% 15 2,000 0.60 15% 10 1,500 1,251 1,000 5 0.40 10% 583 500 0 0 0.20 5% (Mn People) (Mn TCS Infosys HCL Wipro 0.00 0% Number of acquisitions since 2015 (LHS) FY17 FY18 FY19 FY20 Digitally Skilled Employees % of Total Employee Disclosed amount spent on acquisitions since 2015 (US$ mn, RHS)
Deal traction increased across players Deal Size Vendor Client Vertical Deal Length (Years) (USD mn) Some recent large deal wins TCS Walgreens Boots Alliance Pharma 1500 10 Infosys Vanguard BFSI 1500-2000 10 Infosys Daimler AG Auto 3200 8 Wipro Metro AG. Retail 700-1,000 5 Source: Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Story in a nutshell Pandemic will be boon for Margins (Large Cap EBIT Margin) A large part of this margin improvement is sustainable Op Margins
23.1% 22.7%
21.7% 21.5% 21.1% 20.7% 20.8%
FY16 FY17 FY18 FY19 FY20 Q1FY21 Q2FY21
Top-5 IT companies to grow at significant pace over FY20-23E And expected to experience ~260 bps margin expansion 80,000 14% 1,30,000 24% 12% 70,000 12% 23% 1,00,000 23% 23% 60,000 10% 9% 23% 7% 8% 22% 50,000 7% 8% 8% 70,000 22% 7%
40,000 6% cr INR 22% USD mn USD 21% 30,000 4% 40,000 21% 21% 21% 20,000 2% 1% 10,000 0% 10,000 20% FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23 FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23
Revenue (LHS) USD Revenue growth (YoY) (RHS) Op Profit (LHS) Op Margins (RHS)
Infosys is expected to lead the revenue growth over FY20-23E EBIT Margin expansion for Infosys would be highest closely followed by HCL Tech 30000 12% 28% CAGR 26.6% CAGR CAGR 26% 24.6% 10% 24.8% 25000 6% 9% 10% 24% 22% 22.5% 20000 CAGR 8% 21.3% 6% 20% 19.6% 18.5% 15000 6% 18% USD mn USD CAGR 16.8% 4% 16% 10000 4% 14% 14.6% 12% 5000 2% 11.0% 10% FY20 FY21E FY22E FY23E 0 0% TCS Infosys Wipro HCL Tech Tech M TCS Infosys HCl Tech
2020 (LHS) 2023 (LHS) Wipro Tech M
Source: Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Valuation Comparison: Revenue (INR Cr) PAT (INR Cr) P/E (x) Mcap FY20 FY21E FY22E FY23E FY20 FY21E FY22E FY23E FY21 FY22 FY23
Domestic Largecap (INR cr) TCS 11,50,031 1,56,957 1,60,077 1,76,359 1,96,133 32,348 32,900 37,504 43,225 33.0 29.0 25.0 Infosys 5,44,354 90,791 99,184 1,10,535 1,26,712 16,805 18,926 21,847 25,699 28.7 24.9 21.1 HCL Tech 2,64,067 70,678 75,376 83,100 93,153 11,062 12,364 14,351 16,951 21.4 18.4 15.6 Wipro 2,25,356 60,505 61,083 64,415 69,530 9,930 9,991 10,672 12,526 22.0 21.0 18.0 Tech Mahindra 96,336 36,868 37,914 41,259 44,774 4,039 4,200 4,418 5,257 21.0 20.0 17.0
Domestic Midcap (INR cr) LTI 66,952 10,879 12,286 14,466 16,464 1,520 1,760 2,109 2,519 39.1 32.7 27.7 Mphasis 28,559 8,844 9,787 11,010 12,312 1,185 1,227 1,444 1,637 23.0 20.0 17.0 Mindtree 27,629 7,764 7,925 9,054 10,220 631 867 962 1,174 32.2 29.0 23.7 LTTS 25,704 5,619 5,483 6,319 7,234 822 770 960 1,139 32.0 26.0 22.0 Persistent 11,702 3,566 4,123 4,597 5,274 340 422 488 587 29.0 25.0 21.0
Non Domestic (USD mn) Accenture 1,69,801 44,327 47,805 51,290 54,580 5,108 5,308 5,758 6,234 31.0 28.0 26.0 IBM 1,10,438 77,147 74,785 76,468 77,197 9,431 10,503 11,203 11,853 11.0 10.0 9.0 Cognizant 42,461 16,783 17,628 18,686 19,967 1,842 2,080 2,266 2,628 20.0 18.0 16.0 Capgemini 21,664 14,125 16,909 17,776 18,838 856 1,262 1,412 1,481 21.0 19.0 17.0 EPAM 19,488 2,294 3,209 3,929 4,909 261 443 551 729 47.0 38.0 29.0 Source: Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Indian IT sector: Growing stronger through multiple cycles In the past, major crises have led to a sharp increase in outsourcing and offshoring, particularly to India. During such trying times, Indian IT companies have moved up in the maturity curve and provided solutions to the changing needs of global clients in a cost effective and efficient manner.
The First Wave (FY02-09): The First Wave happened after the Y2K problem in 2000 and lasted until the Global Financial Crisis (GFC) in 2008. Between 2001-2008, Indian IT exports grew 6x (albeit on a low base) to USD48bn. In terms of employees, the industry added close to 2mn people. ADM and System Integration were the growth drivers back then.
Indian IT exports grew 6x during FY02-09… …and the industry added ~2mn new jobs back then
48 3
2
2 ($ Bn) ($
18 Jobs) (MN 1
8 1
0 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY02 FY09
Source: NASSCOM, Industry Sources, Edelweiss Wealth Research
The Second Wave (FY10-16): The Second Wave started post the GFC. Traditional cost saving services – especially Infrastructure Management Services (IMS) – drove growth for Indian IT. The industry consistently grew over 15% for 3-4 years before growth normalised to high single digits. The shift to Cloud-based infrastructure and higher use of automation tools resulted in Indian IT firms exploring new ways of selling IT solutions, leading to a shift from labour-cost arbitrage to business transformation through Digital technologies.
Indian IT exports doubled during FY10-16 Sharp bounce-back in IT exports post crisis phase Exports YoY Growth (%) 108 45
36 Dot 76 com Digital, Cloud buble ($ Bn) ($ 27 & loT-led 50 IMS-led growth (%) ADM and 18 SI, let growth expected Post growth Lehman 9 crisis
0 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 Source: NASSCOM, Edelweiss Research, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
The Third Wave – Covid-19 to bring in tech capex and outsourcing: As Work from Anywhere (WFA) is becoming the new accepted norm, an increasing number of technology roles globally are finding their way to India. According to various global surveys, several Fortune 500 companies are planning to have few of their employees Work from Home (WFH) permanently. We believe this will lead to aggressive adoption of Digital technologies and help companies with cost savings, leading to further growth in outsourcing.
IT outsourcing to pick up sharply post Covid-19 on back …across key industry verticals of large cost take-out deals…
IT Outsourcing penetration 78% 77% 76% 72% 71% 70% 74%
68% 73% 67% 67% 66% 65% 65% 64% 64% 64% 63% 62% 61% 72% 72% 59% 58% 71% 70% 68% 67% 66% 65% 64% IT Outsourcing penetration IT Outsourcing 62% 62% 60% FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23 FY24 BFSI Communications Manufacturing Retail FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23 FY24 Source: Gartner, Edelweiss Wealth Research
Despite multiple storms in the past, Indian IT has always bounced back sharply…. Indian IT firms were successful in riding multiple technology waves such as the shift from Mainframe to client-servers, Y2K, internet and e-commerce, social media and mobile. The domestic IT services industry has grown multi-fold over the last two decades – from USD8bn in FY00 to USD191bn in FY20.
Indian IT sector grown multi-fold over last two decades Services have the lion’s share of total IT sector
44 16 38 34 ($ Bn) ($
($ bn) ($ 40 147 191 24 98 3 10 50 97 5 18 FY00 FY05 FY10 FY15 FY20 IT Services ER&D BPM Hardware Total IT Export IT Domestic Products
Source: NASSCOM, Industry Sources, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
… and gained market share globally While global IT spending registered 3% CAGR over CY10-19 to ~USD1.1tn, Indian IT reported 14% CAGR during the same period, taking its market share from 3% in 2010 to 9% currently. While FY00- 09 was a decade of growth, the last decade was that of consolidation – over FY10-19 the industry succeeded in decoupling revenue and employee growth.
Indian IT industry’s market share gain over 2010-20 Indian IT CAGR much higher than global IT 16% 1200 9% 10% 14% 1000 9% 14% 800 8% 12% 7% 600 6% 10% 6% 400 5% 8% 200 3% 4% 6% 0 3% 4% 3% 2010 2015 2020 2% Global IT Services 0% India IT Services Export Industry Domestic Indian IT services as a % of global IT Indian IT 10yr. CAGR
Source: NASSCOM, Gartner, Industry Sources, Edelweiss Wealth Research
Despite being labelled labour-arbitrage, Indian IT delivers highest profitability… Indian IT has been labelled a labour-arbitrage industry. Despite this, Indian tech companies have reported higher margins than the best global tech companies. In H1FY21, TCS and Infosys’ EBIT margins were almost double the margins of Capgemini and Cognizant. Even mid-sized companies like L&T Infotech (LTI), Mphasis and Mindtree have reported better EBIT margins than their large global peers.
Indian IT reports highest profitability compared to global peers EBIT Margin FY12 FY15 FY18 FY20 H1FY21 Domestic large-size companies TCS 28% 24% 25% 25% 25% Infosys 29% 26% 24% 21% 24% HCL Tech 15% 22% 20% 20% 21% Wipro 16% 19% 15% 17% 18% Tech Mahindra 12% 16% 12% 11% 12% Domestic mid-size companies LTI 0% 0% 14% 16% 21% Mphasis 16% 13% 15% 16% 23% Mindtree 14% 19% 14% 11% 16% LTTS 0% 14% 13% 17% 13% Persistent Systems 20% 21% 14% 13% 14% International companies CY12 CY15 CY18 CY19 H1FY20 Capgemini 8% 9% 9% 10% 12% Accenture* 13% 14% 15% 15% 15% Cognizant 19% 17% 17% 15% 13% EPAM 12% 12% 13% 13% IBM 22% 22% 18% 16% 8% *Accenture numbers are for financial year Sept-August Source: Company Data, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
… and cash flow generation is also improving IT services companies are characterized by healthy free cash flow generation as their capex requirements are minimal. Over the last few years, such companies have improved their Cash-to- Profit ratio.
Cash flow conversion for Indian IT firms has improved over last few years CFO as % of Net Profit FY15 FY16 FY17 FY18 FY19 FY20 Domestic large-cap TCS 98% 86% 105% 109% 100% 109% Infosys 87% 91% 98% 97% 100% 114% HCL Tech 76% 97% 112% 99% 93% 112% Wipro 103% 108% 129% 113% 143% 124% Tech Mahindra 93% 105% 145% 94% 103% 108% Domestic mid-cap LTI 84% 103% 120% 76% 92% 108% LTTS 93% 126% 91% 81% 105% 78% Mindtree 112% 76% 156% 99% 84% 131% Mphasis 91% 109% 84% 86% 88% 111% Persistent Systems 107% 92% 95% 130% 123% 95% Source: Company Data, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Shareholders benefit through buy-backs and dividend payments Indian tech companies have articulated a clear and predictable dividend distribution policy over the past 3-5 years, which is largely linked to free cash flows. TCS has been consistent with its cash flow returns over the past three years – its total pay-out ratio as a percentage of FCF stands at 95-105%.
Large-caps and few mid-caps are sharing significant part of profit as dividends/buy-backs FY16 FY17 FY18 FY19 FY20 Large-caps TCS Net Income 24,270 26,289 25,826 31,472 32,340 Div. + Buy Back as % of Net Income 35% 96% 36% 83% 99% Infosys Net Income 13,489 14,353 16,029 15,410 16,639 Div. + Buy Back as % of Net Income 51% 48% 128% 24% 74% HCL Tech Net Income 5,602 8,606 8,722 10,120 11,057 Div. + Buy Back as % of Net Income 40% 39% 60% 50% 12% Wipro Net Income 8,899 8,500 8,001 8,993 9,707 Div. + Buy Back as % of Net Income 33% 38% 144% 6% 115% Tech Mahindra Net Income 2,992.9 2,812.9 3,799.8 4,297.6 4,033.0 Div. + Buy Back as % of Net Income 21% 44% 25% 84% 68% Mid-caps LTI Net Income 836 971 1,112 1,516 1,520 Div. + Buy Back as % of Net Income 78% 20% 33% 30% 32% Mphasis Net Income 669 792 838 1,073 1,185 Div. + Buy Back as % of Net Income 50% 53% 171% 136% 42% Mindtree Net Income 552 419 570 754 631 Div. + Buy Back as % of Net Income 38% 40% 73% 24% 78% LTTS Net Income 419 425 506 769 822 Div. + Buy Back as % of Net Income 0% 21% 16% 26% 27% Persistent Systems Net Income 277 301 323 352 340 Div. + Buy Back as % of Net Income 23% 24% 25% 41% 83%
Source: Company Data, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Digital and Cloud to drive growth; Pandemic to accentuate adoption rate
“Covid-19 is the Henry Ford moment of the Digital era. On an average, we are only 20% in the Cloud currently and we think we will get to 80-85% across most industries by 2025. We believed it was a decade-long transformation but Covid-19 has speeded it up. There are leaders in every industry in terms of digitization, but we are now seeing a broad move towards a flip from 20:80 to 80:20 (in terms of digitization legacy),” — Ms. Julie Sweet, CEO - Accenture
Digital transformation to rev up IT spends Businesses around the world are recalibrating their business models, operations, processes and product/services portfolio to the changing customer landscape. Currently, technologies are deeply interwoven into every industry and across entire industry value chains. According to NASSCOM, global technology and business services spends are expected to reach USD4tn by 2025; of this, 60% would be in Digital.
2014 2020 2025E
Source: NASSCOM, Edelweiss Wealth Research
Global Digital IT services spending is estimated to reach USD900bn (at 16.5% CAGR) by FY25E from USD490bn currently. Currently, Digital makes up more than 30% of the total USD190bn Indian IT exports.
Next Gen technologies to drive incremental growth in IT services spending
Source: Wipro analyst day presentation 2020, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
BFSI, Retail and Hi-tech leading Digital adoption BFSI, Retail and Hi-tech are the leading adopters of Digital services. Adoption in manufacturing has also started picking up. These are the main areas of operations for Indian IT services companies, and thus, higher adoption of Digital should drive growth for these companies hereon.
Industry wise adoption of Digital services
20-25% 17-20%
10-12%
5-7% 5-7% 5-7% 3-5%
BFSI Electronics and Retail Energy & Manufacturing Public Sector Healthcare & hi-tech distribution & Utilities life sciences CPG
Source: Everest Group, Edelweiss Wealth Research
Global Cloud computing market to surpass USD800bn by 2025; Pandemic is a boon Covid-19 is a boon for technology players as it has unleashed exponential use of technologies. And this, we argue, would drive technological spends across the value chain. The biggest beneficiaries will be Cloud providers as increased data usage will accelerate enterprise migration to an efficient frontier, notably Cloud.
Over the last decade, the global Cloud computing market grew 6x to USD370bn. We expect this strong momentum to continue and reach USD870bn by 2025. According to our estimates, Cloud will constitute 38% of the overall technology spending in CY25E (v/s 15% in CY15 and 25% in CY20E).
Cloud computing to grow exponentially over next 5 years Cloud spending contribution to overall IT to rise 38% 832 32% 623 25%
(US$ bn) (US$ 371 15%
172
49
CY10 CY15 CY20 CY23 CY25E CY15 CY20E CY23E CY25E
Source: Gartner, Industry Sources, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Source: NASSCOM, Edelweiss Wealth Research
Growth in largely consolidated Public Cloud market to benefit Indian System Integrators The Public Cloud market valued at USD227bn in 2019 is largely consolidated among few players. Two players – Amazon and Microsoft – jointly hold 51% of the overall market. These companies are growing at breakneck speed – the market leader AWS is clocking 30-35% YoY growth while Microsoft Azure with 45-50% YoY growth is fast catching up. This growth should rub off on Indian IT players’ Cloud practice as they are the preferred partners of these large global Public Cloud providers.
Public Cloud services – market share trend Quadrant for Cloud infrastructure and platform services 45%
35%
25%
15% Microsoft 5% Share of worldwide revenues worldwide of Share -5% Q116 Q216 Q316 Q416 Q117 Q217 Q317 Q417 Q118 Q218 Q318 Q418 Q119 Q219 Q319
Amazon Others Microsoft Google Alibaba
Source: Gartner, Company Data, Industry Sources, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
According to Gartner Research, the Public Cloud market should reach USD354bn by 2022 (at 16% CAGR over 2019-22). While application services will remain the largest portion of the Cloud business, infrastructure will continue to grow at a faster pace.
Public Cloud spending estimated at 16% CAGR over 2019-22 CAGR ($ Bn) CY18 CY19 CY20 CY21 CY22 CY19-22 Cloud Application Services (SaaS) 85 99 116 133 151 15% Cloud System Infrastructure Services (IaaS) 32 40 50 61 74 22% Cloud Application Infrastructure Services (PaaS) 26 32 39 48 58 21% Cloud Business Process Services (BPaaS) 41 43 46 50 53 7% Cloud Management and Security Services 10 12 13 15 17 13% Total Market 196 227 266 308 354 16% Source: Gartner, Edelweiss Wealth Research
Hybrid multi-Cloud adoption to drive growth for IT outsourcing companies Cloud adoption remains the key for business transition, which can be gauged from the growth in Public Cloud. However, the end state for large enterprises is likely to be hybrid multi-Cloud as opposed to just Public Cloud. Enterprises have realized that Cloud is not just an end goal but a key enabler for successful Digital transformation. This should drive secular demand for Cloud migration, cyber-security, and multi-Cloud services. The combination of secular adoption of hybrid multi-Cloud and increasing service intensity of Cloud spending (across SaaS/PaaS/IaaS) should lead to significant demand for Cloud-led infrastructure services for Indian tech companies over the next 5-10 years.
AI adoption moving from basic automation to scalable intelligence Thanks to Digital transformation, large companies were able to enhance their response to competition from native Digital firms and keep up with customer demand for innovation. This has driven the need for automation of legacy processes, which would not only speed up the enterprise but also the usage of advanced analytics to create new areas of differentiation.
Large-scale AI adoption is driving (a) significant transformation initiatives underpinned by several Indian tech companies, and (b) many consulting and system integration projects for Indian tech companies – a mega trend, which would stay over the next decade.
The automation to AI continuum – a journey enterprises are taking
Source: Avasant, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Technology to emerge as the fundamental bedrock for global growth The global economy has been in throes of a slowdown over the past few years. Despite this, the technology industry is likely to grow 4.5% in 2020 to reach USD2.5tn. Enterprise software is the fastest growing at 10.5%. Additional impetus is coming from the focus on Digital technologies, especially analytics and legacy system modernisation.
Globally, incumbent enterprises alone (native Digital start-ups aside) are expected to generate technology products and services worth half of the USD100tn global GDP by 2025. Nine Digital technology areas will emerge as the fastest-growing with the highest impact, and will have the combined potential to deliver one-third of the USD100tn global GDP.
FOUNDATIONAL TECHNOLOGIES Key components Impact potential (2020-2030) Cloud Management Software Data Center Hardware USD6.2tn global GDP impact by 2025 High-Speed Networks
Cloud Computing SaaS/PaaS Apps & Infrastructure Data Analytics – AI-Based 175 zettabytes of data created, 50% of which will & Traditional be stored in public Cloud
Big data and Analytics BI/ Visualization Security Intelligence Detection USD6tn global GDP impact by 2025 Remediation Adaptation End-User Education Cyber Security ADVANCED TECHNOLOGIES Key components Impact potential (2020-2030)
AI Algorithms Machine Learning (ML) USD6.7tn global GDP impact by 2025 Deep Learning
Artificial Intelligence
Consumer Wearables USD6.2tn global GDP impact by 2025 Advanced, Low-Cost Sensors >1tn IoT things installed Wireless/NFC Devices Internet of Things (IOT)
Additive Manufacturing USD0.6tn global GDP impact – 35-60% costs saved Rapid Prototyping per printed product
3d Printing Robotic Dexterity Sensors USD4.5tn global GDP impact by 2025 Distributed Robotics Robotics Robotic Exoskeletons
Distributed Ledger Technology (DLT) 10% of global GDP – USD125tn* – stored in Cryptocurrencies blockchains by 2027 DApps Blockchain
Virtual Reality (VR) Augmented Reality (AR) USD1.5tn of student debt freed up in the US alone Mixed Reality (MR) Extended Reality (XR) Immersive Media Source: NASSCOM, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Indian companies are transforming to ride Digital and Cloud wave
Emerging technologies gaining significant heft for Indian IT companies We believe Cloud, Digital and AI adoption are in a stage where technology has largely matured with standardized Digital solutions (these can be customized based on business/client requirements). This standardization and wide-scale adoption led front-to-back integration of entire IT stacks including applications, database, middleware and IT hardware. Each of these layers is up for modernization towards SaaS, PaaS and IaaS.
Three-pronged approach of Indian IT companies:
1. Signing large managed service contracts: Indian tech companies have successfully absorbed enterprise megatrends with appropriate cost proposition, which deepened their relationships with top clients. Thus, quantity and quality of large deal wins has increased for Indian tech companies.
Deal traction increased across players Deal Size Deal Length Vendor Client Vertical (USD mn) (Years) Domestic large-cap TCS Walgreens Boots Alliance Pharma 1500 10 Infosys Vanguard BFSI 1500-2000 10 Infosys Daimler AG Auto 3200 8 Wipro Metro AG. Retail 700-1,000 5 Domestic mid-cap LTTS Major US oil Giant Engineering 100 5 Mindtree Philips Hi Tech 150-200 - Birlasoft Invacare Pharma 240 10 Source: Company Data, Edelweiss Wealth Research
Companies have reported significant growth in TCV over the last few quarters. Also, number of large clients across companies is increasing, which indicates more traction in deal wins and higher engagement with Fortune 500 companies.
TCV across companies are robust in last few quarters Traction in client addition is also strong
TCV (USD mn) 60 Domestic Large Cap Domestic Mid Cap
10,000 50 No of clients 8,000 40 No of clients above $ 10 mn 6,000 30 above $ 100 mn 4,000 20 2,000 10 - 0 LTI TCS LTTS Wipro Infosys Q3FY19 Q4FY19 Q1FY20 Q2FY20 Q3FY20 Q4FY20 Q1FY21 Q2FY21 HCL Tech HCL Mindtree Q3FY19 Q4FY19 Q1FY20 Q2FY20 TCS Infosys Tech Mahindra Mphasis Q3FY20 Q4FY20 Q1FY21 Q2FY21 Source: Company Data, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
2. Most IT players have made small and relevant skill-based acquisitions: Indian tech companies were earlier averse to investment during the initial phase of the Digital cycle. However, after realising the need, large companies started acquiring small and niche firms with capabilities in newer areas of technologies. An interesting trend of acquisition activity in IT has been ‘acqui- hiring’, where a company is bought for the capability it possesses. This creates a direct link between business strategy and talent creation.
Indian tech biggies are aggressively acquiring small and niche companies across new areas of expertise Date Acquirer Target Area of Expertise Consideration (USD mn) Nov, 20 TCS Postbank Systems Deutsche Bank IT services Nov, 20 TCS Pramerica Prudential Financial Inc (PFI) Technology Partner Nov, 18 TCS BridgePoint Group Acquire expertise in US Retirement services
Oct, 20 Infosys Blue Acorn iCi Digital commerce and Analytics, 125 Sep, 20 Infosys Kaleidoscope Product design and development 42 Sep, 20 Infosys GuideVision ServiceNow Elite Partner 33 Feb, 20 Infosys Simplus Salesforce Partner 128 Apr, 19 Infosys Stater N.V. Mortgage services 75 Jan,19 Infosys WongDoody Advertising and creative strategy services 75 Oct, 18 Infosys Fluido Oy Salesforce advisor and consulting partner 72 Aug, 17 Infosys Brilliant Basics Product design and customer experience 8 Apr, 17 Infosys Skytree Machine learning - Net Spend 558 Sept, 20 HCL Tech DWS Technologies IT services in Australia and New Zealand 158 Jul, 19 HCL Tech Select IBM products security, marketing, commerce, and Digital solutions 1,800 Sept, 19 HCL Tech Sankalp Semiconductor Technology design services firm 25 June, 18 HCL Tech ETL Factory Automation 9 Apr, 17 HCL Tech Urban Fulfilment Services Mortgage BPO Services 30 Jan, 17 HCL Tech Butler America Aerospace Engineering & Design 85 Net Spend 2,107 Oct, 20 Wipro Encore Theme Technologies SaaS Specialist 13 Oct, 20 Wipro Eximius Design End to End IOT Service & Solution Provider 80 Jul, 20 Wipro We Are 4C Salesforce implementation 74 Jul, 20 Wipro IVIA System development, consulting and project management 22 Feb, 20 Wipro Rational Interaction Digital customer experience consultancy. 52 Computer Aided Design (CAD) and Product Lifecycle Management Oct, 19 Wipro ITI 45 (PLM) Oct, 16 Wipro Appiro Cloud transformation practice 500 Net Spend 786 Oct, 20 Tech M Tenzing Group Consulting 30 Oct, 20 Tech M Momenton Engineering Services 10 Apr, 20 Tech M Zen3 Infosolutions Software Solution 64 Feb, 20 Tech M Cerium Systems Engineering Services 33 Nov, 19 Tech M BORN Digital transformation and enterprise commerce solutions 95 Feb, 19 Tech M Dynacommerce Holding Digital Transformation and Customer Experience 17 Net Spend 249 Source: Company Data, Edelweiss Wealth Research
16
Indian IT Services Growing from strength to strength
3. Considerable resources spent on training workforce in Digital space: Organisations are focusing on skill development processes tailored for the Digital era. Infosys has created more than 75 new courses to make its employees future ready. Cognizant has reskilled and upskilled its associates through Cognizant Academy. Wipro uses TrendNxt, a skill-based learning framework, which aims at enhancing employees’ technical knowledge.
India’s Digitally skilled employees grew 3x in 4 years Large companies considerably reskilled their employees
1.00 25% 4,48,464 0.90 0.80 20% 3,35,000 0.70 0.60 15% 0.50 1,75,690 0.40 10% 1,30,000 0.30 (Mn People) (Mn 0.20 5% 0.10 0.00 0% Number of Employees Trained on Digital FY17 FY18 FY19 FY20 Digitally Skilled Employees % of Total Employee TCS Wipro
Source: Company Data, Edelweiss Research, Edelweiss Wealth Research
These Three-pronged approach has led to significant penetration in Digital world Historically, Indian IT industry has been a late beneficiary of any major technology change globally. Over the past few years, Indian IT companies have battled Cloud-led disruption as well as Digital transition. However, during this painful period, the Digital base has gained significant heft – it contributes 30%+ to revenue now and this pace is expected to sustain.
Indian Tech companies have significantly penetrated Digital world over last few years Digital as % Revenue Q4FY17 Q4FY18 Q4FY19 Q4FY20 Q2FY21 TCS 18% 24% 31% NA NA Infosys 24% 27% 34% 42% 47% HCL Tech 13% 15% 19% 19% 21% Wipro 22% 27% 35% 41% 41% LTI 28% 33% 38% 41% 43% Mindtree NA 35% 37% 39% NA Source: Company Data, Edelweiss Wealth Research
17
Indian IT Services Growing from strength to strength
Vendor consolidation to lead further market share gains We expect the industry’s market structure to remain fragmented. However, this could enable sharply positioned Indian tech companies to outgrow the market. We have analysed recent management commentary (top domestic IT companies) around vendor consolidation and found a positive trend.
Company Commentary around vendor consolidation While there were a few formal vendor consolidation exercises, customers have TCS been reassigning many small-sized engagements from existing incumbents to TCS across our customer spectrum. We will definitely see a consolidation, all the conversations our leaders have been Infosys having indicate clients want to consolidate and reduce the number of suppliers to one or two or three. Of course, an easy low-hanging fruit is what we call tail vendor consolidation. While many big companies have a few large partners, they have a long list of tail HCL Tech vendors and there is an emphasis to consolidate, which is mostly coming at our rate cards and our normal pricing. Many of our top accounts have gone through vendor consolidation exercises, and Mphasis we have managed to retain preferred vendor status in all of them. This includes accounts in our top-5 list as well. Clients are looking for either cash generation or cash savings. So, we are seeing L&T Infotech certain large deals, which includes vendor consolidation. We see net gain possibilities in many of these large consolidation deals. Source: Company Data, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Initial round of investment over; Work from Anywhere (WFA) to benefit margins
IT companies grappled with margin pressure over last few years Over the last 2-4 years, margins of IT companies have come under pressure due to (a) investments being needed in Digital across sales, solution building and staffing, (b) resource costs in Digital being higher, and (c) legacy drag setting in with pricing/cost pressures as clients are looking to optimize spends and channelize savings towards Digital.
Large/midsized domestic companies experienced margin pressure over last five years 25% 8% 6% 5% 5% 6% 20% 21% 3% 19% 4% 15% 17% 14% 2% 10% -1% -2% 0%
5% -2%
0% -4% FY15 FY16 FY17 FY18 FY19 FY20 Domestic Large Cap - Average Margins Domestic mid cap - Average op Margins INR Depreciation against USD
Source: Company Data, Edelweiss Wealth Research
Supply-side squeeze impacted margin performance: The onsite staffing model for the industry has undergone a structural change. Difficulty in getting requisite visas, high visa rejection rates and delays due to escalation in request for evidence (RFE) impacted the availability and cost of manpower. Higher attrition in the domestic market and lack of visa availability in the international market was a double whammy on IT companies’ profitability. Companies were forced to do a trade- off between local hiring (which entails utilization risks during a downturn) and hiring sub- contractors (which is costly but provides utilization flexibility).
Indian IT faced highest H1B visa rejection in recent past Employee cost as proportion of total cost is increasing 59% 100%
80% 39% 11% 12% 12% 37% 8% 9% 10% 11% 11% 32% 60% 27% 40% 67% 69% 69% 68% 68% 69% 69% 70% 15% 20%
0% TCS Larsen & Tech M Wipro HCL Tech Infosys FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 Toubro Employee cost Suncontracting cost Depreciation Denial Rate by Domestic IT Companies Facility expenses Travel cost Other costs
Source: Company Data, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Work from Anywhere (WFA) to benefit margins over long term We believe the initial round of Digital investment is over for IT companies. Digital business has now reached a healthy size, which offers economies of scale. Finally, the Covid-19 pandemic has engineered a structural shift in the mindset of clients as well as service providers to re-evaluate the workforce required onsite. This will not only save cost for clients but will also be margin accretive for service providers.
An initial sign of this was visible in the robust Q2FY21 margin performance due to pick-up in revenue growth, continued cost savings on travel and increasing offshore mix.
Large-cap IT companies reported ~300bps EBIT margin …mid-cap IT companies also followed suit improvement sequentially in Q2FY21…
23.1% 18.2% 22.7%
21.7% 16.1% 21.5% 15.6% 21.1% 20.7% 20.8% 14.7% 14.8% 14.4% 14.2%
2016 2017 2018 2019 2020 Q1FY21 Q2FY21 2016 2017 2018 2019 2020 Q1FY21 Q2FY21
Source: Company Data, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
We believe a large part of this margin improvement is sustainable and have five reasons supporting our theory.
1. Sub-contracting cost to remain muted: Since 2016, sub-contracting costs have increased across companies. However, it has started coming under control over the last two quarters post the pandemic. We believe the WFA model gave IT companies the flexibility to hire talent from anywhere and build delivery capabilities irrespective of geographic requirements. Most importantly, the norms for H1-B visa have also been relaxed, which should further benefit IT companies.
Subcontracting cost for IT companies is decreasing Subcontracting cost FY12 FY15 FY18 FY20 Q1FY21 Q2FY21 as a % of revenue Infosys 2 % 4 % 6 % 7 % 6 % 6 % Wipro 9 % 11 % 15 % 14 % 14 % 13 % Tech M 8% 13% 13% 15% 14 % 13% Mindtree 3 % 5 % 6 % 8 % 6 % 6 % Source: Company Data, Edelweiss Wealth Research
2. Lower attrition expected to be the norm and benefit margins: Attrition rate is a forward- looking indicator of a company’s operational performance. Lower attrition rate of a company can be interpreted as it having a healthy work environment, strong revenue growth potential and better operational performance.
Attrition for IT companies has declined significantly over the last two quarters, although, it can be argued that a large part of this is related to the pandemic and is not sustainable. However, we believe attrition will settle down at a lower level, probably in mid-teens for most companies, which should boost margins going ahead.
Attrition rate declined significantly over last two quarters FY12 FY15 FY18 FY20 Q1FY21 Q2FY21 Domestic large-cap TCS 12.2% 13.8% 11.0% 12.1% 11.1% 8.9% Infosys 15.3% 19.8% 18.7% 17.4% 11.7% 7.8% HCL Tech 14.8% 16.4% 15.6% 16.8% 14.6% 12.2% Wipro 17.5% 16.5% 16.8% 14.7% 13.0% 11.0% Tech M 16.0% 18.0% 17.0% 20.0% 17.0% 14.0% Domestic mid-cap LTI 14.8% 16.5% 15.2% 18.4% LTTS 13.4% 14.2% 11.4% 10.8% Mindtree 21.0% 17.0% 13.0% 17.0% 16.6% 13.8% Persistent Systems 18.3% 15.5% 14.7% 14.3% 12.7% 10.6% Source: Company Data, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
3. Distributed Agile delivery model to drive margins: To execute Digital projects, agile and DevOps methodologies of delivery are needed, which involve smaller teams working parallelly (as opposed to the traditional waterfall methodologies). This has resulted in lower gross/operating margins across larger and midsized Indian tech companies.
On the contrary, ‘Distributed Agile’ methodologies allow Digital projects to leverage the power of the onsite-offshore model, which can reduce cost of these projects sharply. Large Indian tech companies have been highly successful in convincing customers of their ability to deliver agile Digital projects using offshore (or distributed teams), combination of telepresence, collaboration tools, and clever methodologies. We expect this to spread across Indian tech companies, which would drive margin resilience and recovery over FY20-22.
Infosys’ onsite effort mix declined by 2% in Q2FY21 LTI’s onsite revenue mix also declined 80 bps in H1FY21
49% 30% 49% 30% 49% 48% 29% 29% 28% 48% 48% 28%
46% 26%
Mar-16 Mar-17 Mar-18 Mar-19 Mar-20 Jun-20 Sep-20 Mar 16 Mar 17 Mar 18 Mar 19 Mar 20 Jun 20 Sep 20
Source: Company Data, Edelweiss Wealth Research
4. Covid-19 to optimise SG&A; WFA to accentuate margins: Cost reduction initiatives owing to Covid-19 (e-travel, e-meetings, e-appraisals) will enable enterprises to restructure/re-innovate their businesses substantially to keep margins stable. Certain costs may temporarily decline (travelling costs) while there could be structural changes to the cost structure (lower rental costs) as the WFH culture slowly matures into a semi-permanent state post the pandemic.
SG&A as % of sales declined significantly for most of companies FY12 FY15 FY18 FY20 Q1FY21 Q2FY21 TCS 28.0% 29.2% 17.5% 17.2% 15.8% 14.7% WIPRO 14.8% 13.2% 12.0% 9.7% 13.3% 11.8% Infosys 11.5% 11.7% 11.8% 12.0% 11.0% 10.5% HCL Tech 14.2% 12.4% 11.7% 12.3% 12.4% 12.7% Tech M 15.8% 14.6% 14.7% 14.0% 14.2% 13.3% LTI 16.5% 13.7% 12.4% 13.7% LTTS 13.1% 13.1% 10.9% 12.4% Source: Company Data, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
5. Protectionism measures behind – an added fillip to growth and margins: Over the last few years, the H1B visa issue had become a bone of contention in American elections. As a result, there was a sharp rise in H1B denial rates, which increased from 6-8% on an average to 20-30% over the last three years.
Sharp increase in H1-B denial rates post 2016
30%
24% 21%
15% 13% 10% 8% 7% 7% 8% 5% 6%
CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16 CY17 CY18 CY19 CY20
Source: Company Data, Edelweiss Wealth Research
While visa rejection rates shot up for all players, IT services companies had it worse than other technology product companies.
Indian IT faced highest H1B visa rejection Global services firms faced higher rejection than product companies 59% 52%
41%
39% 37% 32% 27% 19% 15% 15% 15% 12% 15% 7% 9% 9% TCS Wipro IBM TCS Intel Infosys Tech M Tech Apple HCL Tech HCL Google Deloitte Amazon Facebook Microsoft Cognizant Larsen & Toubro & Larsen
Source: Company Data, Edelweiss Wealth Research
The new regime is more open minded to protectionism: The new President-elect of the US – Democrat Mr. Joe Biden – has carved out a more immigration friendly policy than his Republican predecessor. To start with, the Democrats have toed a relatively lenient line. Mr. Biden has categorically stated that he will lift the suspension on issuance of H1B visas as the 45th president of the US within the first 100 days.
In our view, the above mentioned five factors should enable tech companies to absorb a sizable chunk of cost escalations and keep margins stable at current levels. Currency benefits, if any, would directly flow to the bottom line.
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Indian IT Services Growing from strength to strength
Valuation seems expensive optically, Earnings growth to drive stock performance
Indian IT sector outperformed broader markets for major part of last decade The Indian IT index outperformed the broader market for a major part of the past decade (barring FY16-17). Over FY16-17, the Indian IT sector underwent a transition – legacy was on a decline and Digital had not become mainstream yet.
Nifty IT beat broader market for a larger part last decade FY21 – one of the best years of outperformance after FY10 100% 79% 80% 60%
40% 27% 20% 11% 11% 7% 10% 8% 0% 3% 3% 2% 0% -20%
-40% -24% FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21YTD FY21YTD
Nifty Return Nifty IT Return IT index outperformane over Nifty
Source: Bloomberg, Edelweiss Wealth Research
IT companies’ had a dream run in post-Covid world Covid-19 has proved to be a boon for the IT sector as the accentuated pace of Digital adoption has helped in improving the sector’s outlook significantly. From a broader market perspective, the Nifty IT index has meaningfully outperformed the broader market index since the Covid-19 lows made in March 2020.
Since the lows, the IT index has offered a return of ~121% (v/s the Nifty’s return of ~88%). Moreover, from the pre-Covid levels, the IT index has offered a return of ~50% (v/s the Nifty’s return of ~14%). The post Covid-19 rally mirrored the one in FY10, where strong outperformance was seen across mid-cap and large-cap companies.
Large IT companies’ average stock price return is ~120% since Midsize IT companies’ average stock price return is ~150% Covid lows since Covid lows 160% 200%
160% 120% 120% 80% 80%
40% 40%
0% 0% LTI TCS LTTS Nifty Wipro Infosys Nifty IT Nifty Tech M Tech Coforge Mphasis Mindtree HCL Tech HCL Persistent
Return from Pre Covid levels Return from Covid Low Return from Pre Covid levels Return from Covid Low
Source: Bloomberg, Edelweiss Wealth Research
24
Indian IT Services Growing from strength to strength
Recent run-up in price made the valuation expensive The sector’s valuation seems rich when compared to the long-term historical average or the broader market. The sector’s large caps have also experienced material valuation rerating from ~15x to 22x now. The divergence rerating has remained high as TCS and Infosys are trading close to or higher than their historical averages, whereas, Wipro, HCL Tech and Tech M have not re-rated to the level of their previous highs.
TCS trading at historical high multiple of 30x 1-yr forward P/E Infosys outperformed TCS after a decade 31 30 28 27 25 24 22 21 19 18 16 15 13
12 10 1-4-10 1-4-11 1-4-12 1-4-13 1-4-14 1-4-15 1-4-16 1-4-17 1-4-18 1-4-19 1-4-20 1-4-10 1-4-11 1-4-12 1-4-13 1-4-14 1-4-15 1-4-16 1-4-17 1-4-18 1-4-19 1-4-20
Mcap/PAT -2 SD (R) -1 SD (R) Mcap/PAT -2 SD (R) -1 SD (R) Mean (R) 1 SD (R) 2 SD (R) Mean (R) 1 SD (R) 2 SD (R)
New management has created decade-high bullishness in HCL Tech is playing catch-up with its large peers Wipro
25 24 20 20
15 16 12 10 8 5 4 1-4-09 1-4-10 1-4-11 1-4-12 1-4-13 1-4-14 1-4-15 1-4-16 1-4-17 1-4-18 1-4-19 1-4-20 1-10-13 1-10-14 1-10-15 1-10-16 1-10-17 1-10-18 1-10-19 1-10-20
Mcap/PAT -2 SD (R) -1 SD (R) Mcap/PAT -1 SD (R) Mean (R) Mean (R) 1 SD (R) 2 SD (R) 1 SD (R) 2 SD (R)
Sector bullishness has rubbed off on Tech M
23
19
15
11
7
3 1-10-13 1-10-14 1-10-15 1-10-16 1-10-17 1-10-18 1-10-19 1-10-20
Mcap/PAT -1 SD (R) Mean (R) 1 SD (R) 2 SD (R) -2 SD (R)
Source: Bloomberg, Edelweiss Wealth Research
25
Indian IT Services Growing from strength to strength
Mid-cap IT companies were the star performers this cycle. Companies like Mindtree, LTI, and Persistent significantly outperformed large-caps and were re-rated to their historic high valuation levels. In fact, currently companies like Mindtree are trading at a valuation, which is higher than Tech M, Wipro and HCL Tech. LTI is trading at a valuation, which is higher than Infosys and similar to TCS.
LTI’s P/E multiple is equal to TCS Mindtree’s P/E multiple is higher than Wipro/HCL Tech 30 35 25 30 25 20 20 15 15 10 10 5 5 - 1-4-10 1-4-11 1-4-12 1-4-13 1-4-14 1-4-15 1-4-16 1-4-17 1-4-18 1-4-19 1-4-20 21-Jul-16 21-Jul-17 21-Jul-18 21-Jul-19 21-Jul-20 21-Jan-17 21-Jan-18 21-Jan-19 21-Jan-20
PE -2 SD (R) -1 SD (R) Mcap/PAT -2 SD (R) -1 SD (R) Mean (R) 1 SD (R) 2 SD (R) Mean (R) 1 SD (R) 2 SD (R)
Source: Bloomberg, Edelweiss Wealth Research
Should we BUY at this price? The curious case of IT valuation We attempt to address this by answering two questions: 1. How valuation and earnings growth have played out in the past? 2. Do earnings growth justify this valuation?
Historical evidence suggests that a large part of the re-rating happened in the initial phase of the recovery; earning growth drove performance in the second leg: Post the GFC, during the previous cycle in 2009, Indian IT companies (led by TCS and HCL Tech) experienced significant growth in revenue and earnings. Multiple rerating was seen during the initial phase of the rally, after which, earnings growth drove price performance of the stock.
TCS’ journey from INR50,000cr to INR5,00,000cr over FY09-15 Over FY09-15, market cap of TCS increased 10x from INR50,000cr to INR5,00,000cr. Even if we ignore the initial rally from the GFC bottom, market cap of TCS has increased 3.3x over FY10-15. During FY09-15, revenue (in USD terms) increased 2.6x from USD6bn to USD15.5bn. Operating profit increased from INR6,600cr to INR22,683cr while net profit surged 3.8x from INR5,256cr to INR19,852cr in FY15. A large part of the valuation rerating happened during the initial phase when forward P/E doubled during FY09-10. After FY10, TCS’ stock price closely followed its earnings growth. During FY10-15, PAT increased 2.8x and market cap rose 3.3x. TCS’ journey of 10x market cap over six years
TCS FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY09-15 (X) FY10-15 (X)
M Cap (INR Cr) 50,000 1,52,818 2,31,439 2,28,572 3,07,633 4,16,860 5,00,000 10.0 3.3 Revenue ($ Mn) 6,016 6,339 8,186 10,171 11,566 13,443 15,454 2.6 2.4 PAT (INR Cr) 5,256 7,001 9,068 10,413 13,918 19,164 19,852 3.8 2.8 1-yr Forward P/E (X) 7 17 22 16 16 21 21 Source: Company Data, Bloomberg, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
HCL Tech’s journey from INR12,000cr to INR1,30,000cr market cap over FY09-15 Over FY09-15, market cap of HCL Tech increased 10.5x from INR12,000cr to INR1,30,000cr. Even if we ignore the initial rally from the GFC bottom, HCL Tech’s market cap increased 5x over FY10-15. During FY09-15, USD revenue of the company increased 2.7x from USD2.2bn to USD5.6bn. Operating profit increased from INR1,693cr to INR8,069cr while net profit soared 5.5x from INR1,320cr in FY09 to INR7,262cr in FY15. A large part of the rerating happened during FY09-10 when forward P/E doubled in a year. After FY10, the stock price closely followed earnings growth. Over FY10-15, PAT increased 5.8x and market cap rose 5.2x.
HCL Tech’s journey of 11x market cap over six years
HCL Tech FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY09-15 (X) FY10-15 (X)
M Cap (INR Cr) 12,000 24,769 33,984 33,015 54,083 1,04,759 1,30,000 10.8 5.2 Revenue ($ Mn) 2,182 2,704 3,545 4,152 4,687 5,359 5,954 2.7 2.2 PAT (INR Cr) 1,320 1,259 1,647 2,423 4,040 6,488 7,262 5.5 5.8 1-yr Forward P/E (X) 10 15 14 8 8 14 23 Source: Company Data, Bloomberg, Edelweiss Wealth Research
Historical Evidence also suggests that stock selection plays an important role, especially after a broad-based rally:
TCS and HCL Tech were the clear outliers in the previous IT rally: In the cycle spanning FY09-15, TCS and HCL Tech clearly outperformed their other two peers. Also, the divergence in returns highlights the importance of stock selection in the sector.
TCS and HCL Tech were clear outliers in last IT bull cycle FY09-15 M Cap (INR Cr) FY09 FY10 FY11 FY12 FY13 FY14 FY15 Return CAGR Outperformers TCS 50,000 1,52,818 2,31,439 2,28,572 3,07,633 4,16,860 5,00,000 47% HCL Tech 12,000 24,769 33,984 33,015 54,083 1,04,759 1,30,000 49% Underperformer Infosys 75,739 1,49,584 1,85,142 1,63,875 1,65,302 1,87,550 2,53,579 22% Wipro 35,927 1,03,688 1,17,327 1,07,884 1,07,626 1,33,751 1,54,972 28% Source: Company Data, Bloomberg, Edelweiss Wealth Research * We have not included Tech M as the performance will look distorted due to the Satyam merger
27
Indian IT Services Growing from strength to strength
In the short rally over FY17-19, mid-caps have significantly outperformed large-caps: During FY17- 19 when the IT sector experienced rerating, selected midcaps like Mindtree, LTI and LTTS significantly outperformed large caps.
Selected midcaps outperformed large caps in FY17-19 rally FY17-19 Return (INR Cr) FY17 FY18 FY19 CAGR
Mindtree 7,600 12,686 15,500 43% LTI 12,162 23,068 29,305 55% LTTS 7943 12706 16339 43%
TCS 4,78,927 5,44,216 7,50,150 25% Infosys 2,33,559 2,46,845 3,21,861 17% Wipro 1,25,256 1,27,328 1,53,716 11% HCL Tech 1,24,410 1,34,761 1,47,424 9% Tech M 40,334 56,387 68,880 31%
Source: Company Data, Bloomberg, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Do earnings growth justify this valuation? At the outset, valuations of the IT sector may appear expensive when compared to its historical long-term average valuation matrices. However, valuations should not be seen in isolation. We believe various aspects such as the macro environment, technology cycle, interest rates and earnings expectations, etc. should be factored in.
FY22-23E – Will be a watershed moment for IT sector We believe that FY22-23E will be another watershed moment for Indian IT. We expect revenue to recover sharply due to (a) revival in pent-up demand, and (b) an increasing level of tailwind for Digital solutions owing to enterprises preparing for robust future business continuity plans.
The top-5 large cap IT companies are expected to report 7.3% revenue CAGR over FY20-23E with potentially more upside if reliance on Digital technologies accelerates meaningfully post Covid-19.
Top-5 IT companies to grow at significant pace over FY22-23E Mid-cap IT basket to post ~15% yearly growth over FY22-23E 17% 80,000 14% 6,000 18% 12% 16% 15% 70,000 9% 12% 5,500 14% 5,000 14% 60,000 8% 10% 7% 8% 7% 4,500 10% 50,000 8% 10% 7% 4,000 10%
40,000 6% mn USD USD mn USD 3,500 30,000 4% 3,000 6% 20,000 2% 2,500 3% 1% 2,000 2% 10,000 0% FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23 FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23 Revenue (LHS) USD Revenue growth (YoY) (RHS) Revenue (LHS) USD Revenue growth (YoY) (RHS)
Source: Company Data, Bloomberg, Edelweiss Wealth Research
Operating margins to improve driven by revenue growth We estimate 260bps (from FY20 levels) margin expansion by FY23E for the top-5 Indian IT services firms. EBIT is estimated at 12% CAGR over FY20-23E (v/s 7.8% CAGR reported over FY17-20).
Top-5 IT firms to see 260bps margin expansion over FY20-23E Mid-cap IT basket to report 300bps margin expansion over FY20-23E 1,30,000 24% 7,000 18% 23% 17% 23% 6,000 22% 17% 1,00,000 23% 16% 23% 5,000 16% 16% 21% 4,000 70,000 22% 22% 15% 14% INR cr INR 21% cr INR 3,000 14% 15% 40,000 21% 2,000 14% 15% 21% 14% 1,000 10,000 20% - 13% FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23 FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23
Op Profit (LHS) Op Margins (RHS) Op Profit (LHS) Op Margins (RHS)
Source: Company Data, Bloomberg, Edelweiss Wealth Research
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Indian IT Services Growing from strength to strength
Infosys is our top pick in large-caps followed by HCL Tech. In mid-caps, we prefer Mindtree and L&T Infotech In our analysis and selection of large-caps, we prefer companies with growth outperformance potential and higher margin lever. Among large-caps, we prefer Infosys and HCL Tech. Among mid- caps, we prefer L&T Infotech (LTI) and Mindtree (despite their premium valuation) due to higher growth and better business profile.
Infosys, Indian IT’s poster-boy, is coming back strongly: In FY20, Infosys’ CC revenue grew 10.8% YoY (v/s TCS’ 7.2% YoY), and even in H1FY21, Infosys outperformed its large-cap peers in terms of growth. Under the new CEO, Mr. Salil Parekh, the company has chalked out a strategy to ‘Stabilise’, ‘Consolidate’ and ‘Accelerate. After stabilising operations internally, Infosys is now moving into growth acceleration mode. While TCS was focussed on organic growth by developing competencies and reskilling employees, Infosys was more active in making ‘tuck-in’ acquisitions to develop capabilities and reinvesting in sales and marketing. We believe Infosys’ recent revenue outperformance over TCS would continue in the near term given the deal flow momentum, aggressive acquisition, and strong hiring.
HCL Tech, an aggressive growth chaser: HCL Tech is consistently chasing growth by aggressively acquiring products, platforms and capabilities. Since 2016, HCL Tech has spent USD2.8bn on acquisitions. In FY20, the company reported CC growth of 17% while on an organic basis, growth stood at 11%. Due to its aggressive growth strategy, HCL Tech outpaced Wipro as the third largest IT Company in India. We believe HCL Tech will closely follow Infosys in reporting industry-leading growth over FY20-23E.
HCL Tech saw industry-leading revenue growth due to its Infosys is expected to lead the revenue growth over FY20-23E aggressive acquisition strategy closely followed by HCL Tech
Revenue (USD) Revenue (USD)
CAGR CAGR CAGR 11% 10% 30,000 CAGR 12% 25,000 CAGR 12% 7% CAGR CAGR 8% 8% 25,000 10% 20,000 7% 7% 10% CAGR 8% 20,000 CAGR 5% 8% 15,000 CAGR 5% 6% 15,000 6% 3% 10,000 4% 10,000 4% 5,000 2% 5,000 2% - 0% - 0% TCS Infosys HCL Tech Wipro Tech TCS Infosys HCL Tech Wipro Tech Mahindra Mahindra
FY15 (LHS) FY20 (LHS) CAGR (RHS) FY20 (LHS) FY23 (LHS) CAGR (RHS)
Source: Company Data, Edelweiss Wealth Research
30
Indian IT Services Growing from strength to strength
Infosys to lead margin expansion among large peers: We expect margins to improve for the top-5 Indian IT services companies by FY23E; however, we expect Infosys to have the highest EBIT margin expansion. Infosys should report 350bps margin expansion (v/s 260bps average margin expansion for all five large players).
Historically TCS lead the Margin improvement Going forward, Infosys is expected report higher growth in profitability 28% 28% 26% 26.4% 26% 26.6% 24.6% 24.6% 24.8% 24% 24.0% 24% 22.5% 22% 22.0% 22% 21.3% 21.3% 20% 20% 19.4% 19.6% 19.6% 18.5% 18% 18% 16.8% 16.8% 16% 16% 14.6% 14% 14.2% 14% 12% 12% 11.0% 11.0% 10% 10% FY15 FY16 FY17 FY18 FY19 FY20 FY20 FY21E FY22E FY23E
TCS Infosys HCl Tech TCS Infosys HCl Tech Wipro Tech M Wipro Tech M
Source: Company Data, Bloomberg, Edelweiss Wealth Research
Infosys to lead earnings growth, followed closely by HCL Tech Due to higher top line growth and margin expansion, Infosys should report the highest Net profit CAGR of 14%, followed by HCL Tech’s 13% over FY20-23E.
TCS led growth in Net Profit over FY15-20 Expect Infosys to report higher growth in profitability
PAT (INR Cr) PAT (INR Cr) CAGR CAGR CAGR 35,000 10% 12% CAGR 15% 15% CAGR 50,000 16% 30,000 9% 8% 10% 45,000 CAGR 14% CAGR 40,000 CAGR 25,000 10% CAGR 12% 6% 8% 35,000 9% 20,000 8% 10% 6% 30,000 15,000 CAGR 25,000 8% 2% 4% 20,000 10,000 6% 15,000 4% 5,000 2% 10,000 5,000 2% - 0% - 0% TCS Infosys HCL Tech Wipro Tech TCS Infosys HCL Tech Wipro Tech Mahindra Mahindra FY20 (LHS) FY23 (LHS) FY15 (LHS) FY20 (LHS)
Source: Company Data, Bloomberg, Edelweiss Wealth Research
31
Indian IT Services Growing from strength to strength
TCS & LTI has sector-leading returns… Among large-caps, TCS has the highest return ratios followed by Infosys. The sector returns have declined after FY15-16 due to slower revenue growth, high margin pressure and greater cash piles. However, returns have started to improve for TCS and Infosys over the past three years, given the improvement in earnings and increasing dividend pay-outs as companies have become proactive in returning cash to shareholders. We expect the returns profile of TCS and Infosys to improve further with the sector entering a technology upcycle. On the other hand, HCL Tech’s growth chasing strategies impacted its return profile over the last five years while Wipro’s RoCE is the lowest among peers.
Among our mid cap basket, LTI has sector leading RoCE. With highest growth potential and best return ratios, LTI is trading at industry leading valuation multiple.
TCS and LTI have industry RoCE ROCE FY16 FY17 FY18 FY19 FY20 FY21E FY22E FY23E Large-caps TCS 48% 43% 39% 46% 45% 40% 41% 43% Infosys 32% 31% 30% 33% 33% 34% 38% 40% Wipro 22% 18% 16% 18% 19% 19% 20% 20% HCL Tech 34% 33% 31% 30% 27% 26% 28% 23% Tech Mahindra 28% 23% 26% 27% 22% 22% 23% 24% Mid-caps LTI 47% 46% 40% 45% 35% 34% 36% 42% LTTS 44% 41% 38% 45% 42% 38% 39% 39% Mindtree 31% 22% 26% 30% 23% 25% 27% 28% Persistent 26% 23% 21% 22% 20% 24% 23% 23% Source: Bloomberg, Company Data, Edelweiss Wealth Research
….and hence, it is trading at a premium to all peers
FY22E RoCE v/s P/E on 12-month forward EPS consensus estimates
60%
50% TCS
LTTS 40% LTI
Infosys 30% HCL Tech Mindtree Tech Mahindra 20% Wipro Persistent Systems
10%
0% 15.0 17.0 19.0 21.0 23.0 25.0 27.0 29.0 31.0 33.0 P/E (x)
Source: Bloomberg, Edelweiss Wealth Research
32
Indian IT Services Growing from strength to strength
LTI and Mindtree are our preferred picks in the mid-cap space Since listing in FY16, LTI outperformed its Indian mid-cap/large-cap peers both in revenue growth and margin performance. Strong and stable leadership team with concentrated focus on profitable growth and healthy RoE established LTI as a force to reckon with in the fragmented global IT services market. Looking ahead, we expect LTI to maintain its leadership position on the revenue growth front, driven by robust large deal wins, new client additions and vertically-focused client mining efforts.
Mindtree faced turbulent times after the L&T takeover. The company underperformed its mid-cap peers – EBIT margin declined to 10% in FY20 from 17% in FY15. Under its new leadership, Mindtree has bounced back sharply. The company has done a phenomenal job in penetrating its top client Microsoft. We expect Mindtree to deliver sustained growth led by (a) immense capabilities of the new management post the L&T takeover, (b) fast-growing digital business contribution, which is much higher than industry’s ~30% average, (c) top client Microsoft, which is clocking superlative growth and other clients that are in recovery mode, and (d) higher traction in run your-business offerings.
33
Company Section Infosys Ltd
Revisiting growth after long period of underperformance Debashish Mazumdar The last decade was turbulent for Infosys due to several management changes and Research Analyst [email protected] strategy shifts. However, under the new CEO, Mr. Salil Parekh, the company has chalked out a strategy to ‘Stabilise’, ‘Consolidate’ and ‘Accelerate. After stabilising operations internally, Infosys is now moving into growth acceleration mode. In H1FY21, Infosys was the only large cap to report YoY CC growth, and for 4-5 CMP: INR 1,260 quarters, it has consistently outperformed industry leader TCS. Infosys is well Target price: INR 1,700 positioned to participate in the upcoming technology upcycle due to its Upside: 35% investments over the last three years, which is visible through its recent revenue Rating: Tactical BUY outperformance and positive momentum in deal wins.
Focused Digital transformation strategy paying off well Infosys’ strategy of returning to growth mode is aligned towards Digital transformation opportunities. The company managed to scale its presence in the Digital world through small acquisitions, reskilling internal employees and localisation of talent. As at Q2FY20, Digital contributed 47% of the company’s Bloomberg: INFO:IN revenue – the highest among IT large caps – and is growing at 25-30% YoY. 52-week 509/1,302 range (INR): Higher efficiency to rein in growth and increased margin improvement Shares in issue (crore): 425 With Infosys undergoing restructuring, the company’s operating margin declined by 3% over the last two years to 21.3% by FY20. Higher attrition, high M-cap (INR crore): 5,46,122 subcontracting cost and continuous investment into the Digital business put Promoter holding (%) 12.95 pressure on margins. However, profitability has shown signs of improvement over the last six months with the company reporting EBIT margins of 25.3% during Q2FY21. We believe Infosys offers highest growth potential among the large cap IT universe. While some margin benefits will fade, Infosys could achieve 25% operating margin by FY23E as the cost pressure can be compensated by pickup in revenue growth. Digital business and deal bookings are robust and will help in sustaining growth recovery.
Outlook and valuation: Recommending Tactical BUY Given our expectation of industry leading revenue growth and margin expansion, we believe there is more upside to Infosys’ price, despite 59% increase YTD.
Further, Infosys’ discount to TCS should narrow in the coming months as investors gain confidence on its ability to outperform (or grow in line) TCS consistently. At CMP, the stock is trading at P/E multiple of 22/19x of FY22/23E expected earnings. We recommend ‘Tactical Buy’ with a target price of INR 1,700.
INR crore FY20A FY21E FY22E FY23E Revenues (INR cr) 90,791 99,184 1,10,535 1,26,712
EBITDA (INR) cr) 22,268 27,042 31,016 35,505 EBITDA Margin (%) 24.5 27.3 28.1 28.0 Net Profit (INR cr) 16,809 18,927 21,847 25,699 EPS (INR) 39 45 51 61 EPS Growth (%) 8.1 13.1 15.4 17.6
P/E (x) 28.8 28.7 24.9 21.1 RoACE (%) 8.5 9.3 9.8 10.5 RoAE (%) 25.7 27.6 29.5 31.4 Date: January 8, 2020
Edelweiss Professional Investor Research 34
Infosys Ltd Financials
Income Statement (INR Cr) Balance Sheet (INR Cr) Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Total operating income 90791 99184 110535 126712 Share capital 2122 2123 2123 2123 Cost of revenues 57838 61872 69100 79263 Reserves 63722 69087 74807 84379 Gross Profit 32953 37312 41435 47449 Shareholders funds 65844 71210 76930 86502 SG&A 4712 4582 4421 5069 Minority interest 0 0 0 0 EBITDA 22268 27042 31016 35505 Borrowings 0 0 0 0 Depreciation 2894 3174 3289 3105 Trade payables 4342 3968 3968 3968 EBIT 19374 23868 27728 32400 Other liabs & prov 10354 12438 14172 17172 Add: Other income 2803 1704 1401 1865 Total liabilities 85640 93211 100666 113237 Profit before tax 22177 25572 29129 34265 Net block 12435 16662 15734 13822 Prov for tax 5368 6646 7282 8566 Intangible assets 7186 7112 7112 7112 Less: Other adj 0 0 0 0 Capital WIP 0 0 0 0 Reported profit 16809 18927 21847 25699 Total fixed assets 19621 23774 22846 20934 Less: Excp.item (net) 0 0 0 0 Non current inv 4137 7754 7754 7754 Adjusted profit 16805 18927 21847 25699 Cash/cash equivalent 23304 25113 36586 48250 Diluted shares o/s 426 425 425 425 Sundry debtors 23944 26392 23301 26121 Adjusted diluted EPS 39 45 51 61 Loans & advances 7328 7025 7025 7025 DPS (INR) 28 33 33 33 Other assets 0 0 0 0 Tax rate (%) 24 26 25 25 Total assets 85640 93211 100666 113237
Important Ratios (%) Free Cash Flow (INR Cr) Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Salary hike - Onsite (%) 2.5 -6.2 1.6 2.0 Reported profit 16809 18927 21847 25699 Salary hike - Offshore 2.5 -5.7 -1.5 8.7 Add: Depreciation 2894 3174 3289 3105 Trainee Salary (%) -2.0 2.0 -2.0 0.0 Interest (net of tax) 0 0 0 0 EBITDA margin (%) 24.5 27.3 28.1 28.0 Others 7760 -650 4826 180 Net profit margin (%) 18.5 19.1 19.8 20.3 Less: Changes in WC -2388 922 0 0 Revenue growth (% YoY) 9.8 9.2 11.4 14.6 Operating cash flow 25075 22372 29961 28984 EBITDA growth (% YoY) 6.6 21.4 14.7 14.5 Less: Capex -7569 -7202 -2361 -1193 Adj. profit growth (%) 6.0 12.6 15.4 17.6 Free cash flow 17506 15171 27600 27791
Valuation Metrics Key Ratios Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Diluted P/E (x) 28.8 28.7 24.9 21.1 RoE (%) 25.7 27.6 29.5 31.4 Price/BV (x) 7.4 6.8 6.3 5.6 RoCE (%) 8.5 9.3 9.8 10.5 EV/EBITDA (x) 22.0 18.0 15.4 13.1 Inventory days 0.0 0.0 0.0 0.0 Dividend yield (%) 2.5 2.9 2.9 2.9 Receivable days 89.0 93.0 82.0 71.0 Payable days 38.0 25.0 21.0 18.0 Valuation Drivers Working cap (% sales) 11.5 11.3 5.7 4.9 Year to March FY20A FY21E FY22E FY23E Gross debt/equity (x) 0.0 0.0 0.0 0.0 EPS growth (%) 8.1 13.1 15.4 17.6 Net debt/equity (x) -0.4 -0.4 -0.5 -0.6 RoE (%) 25.7 27.6 29.5 31.4 Interest coverage (x) 0.0 0.0 0.0 0.0 EBITDA growth (%) 6.6 21.4 14.7 14.5 Payout ratio (%) 70.9 72.8 63.1 53.6
Edelweiss Professional Investor Research 35
HCL Technologies Ltd
HCL Tech (HCLT) to be a major beneficiary of Digital and Cloud Debashish Mazumdar Accelerated demand for Cloud, Digital adoption and transformation is expected to Research Analyst [email protected] benefit HCLT greatly as the company has more than 50% exposure to the Digital and Cloud space. HCLT ranks in the upper strata of sector growth trajectory as it has invested in Digital technologies and in building the software business. HCLT has delivered revenues at 11.9% CAGR over FY11-20 while that of the top-4 Indian CMP: INR 960 IT services companies stood at 10.1%. Even after aggressive inorganic moves, the Target price: INR 1,500 company has maintained healthy EBIT margins in the recent past. Upside: 56% Rating: Tactical BUY Focused strategy to drive growth in Service and Software business To grow its Services business, HCLT has chalked out strategies around Mode 1-2-3 offerings. It has combined this with go-to-market approach for vertical market led IT and business services organisation for optimal results. HCLT has spent USD2.8bn on acquisitions since 2016. The company will continue to identify small targets to acquire capabilities in the area of Digital and products. Going ahead, we expect the company’s organic growth to be marginally ahead of the sector average, Bloomberg: HCLT:IN driven by demand for Digital services. 52-week 375/998 range (INR):
Product and Platform to repeat IMS success Shares in issue (crore): 271 While HCLT’s software business/IP strategy has raised investor concerns (regarding efficient use of capital), we believe the segment does provide an M-cap (INR crore): 2,65,451 opportunity to build a credible platform business with limited risk. This is because Promoter holding (%) 60.33 most of the products acquired are established with a predictable cash flow stream. In modern Digital era, HCLT is repositioning the Software business through acquisitions. Management is targeting to repeat the success of IMS in the Product and Platform business. However, for investors to get comfortable on the business, the company needs to show organic growth over the medium term (while maintaining margins).
Outlook and Valuation: Recommending Tactical BUY
HCL Tech is expected to report industry leading growth and margin expansion over FY20-23E. The company’s presence in Infra management and will product will aid in capturing opportunity both in Cloud implementation and digital expansion. At CMP, the stock is trading at P/E multiple of 16/14x of FY22/23E expected earnings. We recommend ‘Tactical Buy’ with a target price of INR 1500.
INR crore FY20A FY21E FY22E FY23E
Revenues (INR cr) 70,678 75,376 83,100 93,153 EBITDA (INR) cr) 16,693 18,850 20,946 24,326 EBITDA Margin (%) 23.6 25.0 25.2 26.1
Net Profit (INR cr) 11,062 12,364 14,351 16,951 EPS (INR) 41 46 53 63 EPS Growth (%) 10.8 11.8 16.1 18.1 P/E (x) 21.1 21.4 18.4 15.6 Date: January 8, 2020 RoACE (%) 27.1 26.6 29.1 34.2 RoAE (%) 23.4 21.9 23.8 28.0
Edelweiss Professional Investor Research 36
HCL Technologies Ltd Financials
Income Statement (INR Cr) Balance Sheet (INR Cr) Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Total operating income 70678 75376 83100 93153 Share capital 528 543 543 543 Cost of revenues 44308 45717 51136 56717 Reserves 51686 60133 59244 60955 Gross Profit 26370 29659 31964 36436 Shareholders funds 52214 60676 59787 61498 SG&A 9677 10809 11018 12110 Minority interest 0 0 0 0 EBITDA 16693 18850 20946 24326 Borrowings 5093 3100 3000 2900 Depreciation 2840 3463 3289 3289 Trade payables 25909 24625 26699 29008 EBIT 13853 15387 17658 21038 Other liabs & prov 0 0 0 0 Add: Other income 193 709 741 695 Total liabilities 83216 88401 89486 93406 Profit before tax 14032 16093 18398 21732 Net block 6244 5223 7346 9468 Prov for tax 2938 3705 4048 4781 Intangible assets 32045 31003 30399 29796 Less: Other adj 0 0 0 0 Capital WIP 0 0 0 0 Reported profit 11062 12364 14351 16951 Total fixed assets 38289 36226 37745 39263 Less: Excp.item (net) 0 0 0 0 Non current inv 10607 11741 11741 11741 Adjusted profit 11062 12364 14351 16951 Cash/cash equivalent 4843 11771 9252 9333 Diluted shares o/s 271 271 271 271 Sundry debtors 17772 17605 19109 20784 Adjusted diluted EPS 41 46 53 63 Loans & advances 11705 11511 12091 12738 DPS (INR) 6 12 36 36 Other assets 5279 5540 6120 6767 Tax rate (%) 21 23 22 22 Total assets 83216 88401 89486 93406
Important Ratios (%) Free Cash Flow (INR Cr) Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Direct costs (%) 62.7 60.7 61.5 61.9 Reported profit 11062 12364 14351 16951 SG&A costs (%) 13.7 14.3 13.3 13 Add: Depreciation 2840 3463 3289 3289 Yield on cash & eqv. 7.5 5 4 4 Interest (net of tax) 0 0 0 0 EBITDA margin (%) 23.6 25.0 25.2 26.1 Others 432 0 0 0 Net profit margin (%) 15.7 16.4 17.3 18.2 Less: Changes in WC -1883 0 -11 -12 Revenue growth (% YoY) 17 6.6 10.2 12.1 Operating cash flow 12452 0 17628 20227 EBITDA growth (% YoY) 19.5 12.9 11.1 16.1 Less: Capex -1700 -345 -4807 -4807 Adj. profit growth (%) 9.3 11.8 16.1 18.1 Free cash flow 10752 0 12821 15421
Valuation Metrics Key Ratios Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Diluted P/E (x) 21.1 21.4 18.4 15.6 RoE (%) 23.4 21.9 23.8 28.0 Price/BV (x) 4.5 3.8 3.9 3.8 RoCE (%) 27.1 26.6 29.1 34.2 EV/EBITDA (x) 14.5 12.4 11.2 9.7 Inventory days 0 0 0 0 Dividend yield (%) 0.7 1.4 4.2 4.2 Receivable days 84 86 81 78 Payable days 159 202 183 179 Valuation Drivers Working cap (% sales) 5 5.4 4.9 4.4 Year to March FY20A FY21E FY22E FY23E Gross debt/equity (x) 0.1 0.1 0.1 0 EPS growth (%) 10.8 11.8 16.1 18.1 Net debt/equity (x) 0 -0.1 -0.1 -0.1 RoE (%) 23.4 21.9 23.8 28 Interest coverage (x) 0 0 0 0 EBITDA growth (%) 19.5 12.9 11.1 16.1 Payout ratio (%) 14.7 26.3 68.1 57.6
Edelweiss Professional Investor Research 37
L&T Infotech Ltd
L &T Infotech (LTI) – a consistent outperformer Debashish Mazumdar Since listing in FY16, LTI has outperformed its Indian mid-cap/large-cap peers – Research Analyst both in terms of revenue growth and margin performance. The last four years has [email protected] seen LTI clock revenue CAGR of 15% (>1.5x of industry average), driven by large deal wins, strong account opening and new logo addition, and focused client mining approach. In H1FY21, LTI reported ~10.5% YoY CC growth, which is by far CMP: INR 3880 the best in the sector. We expect limited impact of Covid-19 on LTI’s revenue, as Target price: INR 4500 large deals won in 2HFY20 are likely to ramp-up in FY21. Looking ahead, we expect Upside: 16% LTI to maintain its leadership position on the revenue growth front, driven by Rating: Tactical BUY robust large deal wins, new client addition and vertically focused client mining efforts.
All round performance and Digital acceleration drives growth Over the last four years, LTI has bagged 21 large deals across verticals. The company’s large deal TCV has crossed USD1bn in the last three years. LTI’s active client crossed 420 in Q2FY21 (v/s 250 in FY16). Focused client mining efforts have Bloomberg: LTI:IN borne fruit as USD20mn/USD50mn client bucket has ramped up from 10/3 in FY16 52-week 1,201/4,199 to 16/6 in Q2FY21. Since Q1FY18, LTI added 223 new logos; of this, 10 new logos range (INR): were large multi-year deals. This suggests increasing awareness of LTI’s capabilities. Moreover, over the last 3-4 years LTI grew its Digital and traditional Shares in issue (crore): 142 businesses, which also aided overall industry growth. LTI’s Digital business (43% M-cap (INR crore): 69,104 of revenue) reported ~34% CAGR over FY17-20, while the traditional business posted 9% CAGR over the same period. Promoter holding (%) 74.36
Diversified customer base, stable leadership, aggressive sales and acquisition programme – secret of LTI’s success LTI enjoys a diversified customer base across geographies and verticals. Strong and stable leadership team with concentrated focus on profitable growth and healthy RoE established the company as a name to reckon with in the fragmented global
IT services market. LTI’s secret sauce of success is its aggressive sales and marketing strategy of opening new accounts, scaling them up and continuously winning large deals. Over the last three years, LTI acquired six companies in the field of Cloud, Data Analytics, DevOps and Temenos Banking Suit.
Outlook and Valuation: Recommending Tactical BUY LTI should continue to outperform on the back of impeccable execution, stable management, an impressive sales and marketing team and expanding Digital offerings. At CMP, the stock is trading at P/E multiple of 28/23x of FY22/23E expected earnings. We recommend ‘Tactical Buy’ with a target price of INR 4500.
INR crore FY20A FY21E FY22E FY23E
Revenues (INR cr) 10879 12286 14466 16464 EBITDA (INR) cr) 2029 2482 2972 3470 EBITDA Margin (%) 18.7 20.2 20.5 21.1
Net Profit (INR cr) 1520 1760 2109 2519 EPS (INR) 86 100 120 142 EPS Growth (%) 0.0 16.1 19.4 18.3 P/E (x) 37.6 39.1 32.7 27.7
RoACE (%) 38.8 40.7 41.9 42.1 RoAE (%) 29.5 31.0 32.4 32.5 Date: January 8, 2020
Edelweiss Professional Investor Research 38
L&T Infotech Ltd Financials
Income Statement (INR Cr) Balance Sheet (INR Cr) Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Total operating income 10879 12286 14466 16464 Share capital 17 17 18 18 Cost of revenues 7359 8351 9715 10969 Reserves 5387 5936 7058 8398 Gross Profit 3520 3936 4751 5495 Shareholders funds 5404 5953 7075 8415 SG&A 1491 1454 1779 2025 Minority interest 1 1 1 1 EBITDA 2029 2482 2972 3470 Borrowings 32 25 25 25 Depreciation 273 322 354 319 Trade payables 0 0 742 850 EBIT 1756 2161 2618 3151 Other liabs & prov 2309 2310 2645 3041 Add: Other income 246 163 121 121 Total liabilities 8825 9281 11396 13241 Profit before tax 2002 2323 2739 3271 Net block 441 451 362 341 Prov for tax 483 564 630 752 Intangible assets 768 777 370 322 Less: Other adj 0 0 0 0 Capital WIP 0 0 1 1 Reported profit 1520 1760 2109 2519 Total fixed assets 1210 1228 733 664 Less: Excp.item (net) 0 0 0 0 Non current inv 0 0 0 0 Adjusted profit 1520 1760 2109 2519 Cash/cash equivalent 2744 3426 5370 6618 Diluted shares o/s 18 18 18 18 Sundry debtors 2754 2606 2406 2795 Adjusted diluted EPS 86 100 120 142 Loans & advances 242 130 148 170 DPS (INR) 35 40 48 57 Other assets 1875 1892 2984 3238 Tax rate (%) 24 24 23 23 Total assets 8825 9281 11396 13241
Important Ratios (%) Free Cash Flow (INR Cr) Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Cost of rev (% ) 67.6 68.0 67.2 66.6 Reported profit 1520 1760 2109 2519 SG&A exp. (%) 13.7 11.8 12.3 12.3 Add: Depreciation 273 322 354 319 Dep. as % of gross block 13.9 12.5 13.1 10.8 Interest (net of tax) 0 0 0 0 EBITDA margin (%) 18.7 20.2 20.5 21.1 Others 394 -351 -111 -15 Net profit margin (%) 14.0 14.3 14.6 15.3 Less: Changes in WC 544 -204 -167 161 Revenue growth (% YoY) 15.2 12.9 17.7 13.8 Operating cash flow 1644 1934 2519 2662 EBITDA growth (% YoY) 7.7 22.3 19.7 16.8 Less: Capex -247 -340 141 -250 Adj. profit growth (%) 0.3 15.8 19.8 19.5 Free cash flow 1397 1595 2660 2412
Valuation Metrics Key Ratios Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Diluted P/E (x) 37.6 39.1 32.7 27.7 RoE (%) 29.5 31.0 32.4 32.5 Price/BV (x) 10.6 9.6 8.1 6.9 RoCE (%) 38.8 40.7 41.9 42.1 EV/EBITDA (x) 26.2 21.1 17.0 14.2 Inventory days 0.0 0.0 0.0 0.0 Dividend yield (%) 1.1 1.2 1.5 1.7 Receivable days 77.0 80.0 63.0 58.0 Payable days 12.0 0.0 14.0 26.0 Valuation Drivers Working cap (% sales) 20.9 16.8 13.1 12.5 Year to March FY20A FY21E FY22E FY23E Gross debt/equity (x) 0.0 0.0 0.0 0.0 EPS growth (%) 0.0 16.1 19.4 18.3 Net debt/equity (x) -0.5 -0.6 -0.8 -0.8 RoE (%) 29.5 31.0 32.4 32.5 Interest coverage (x) 0.0 0.0 0.0 0.0 EBITDA growth (%) 7.7 22.3 19.7 16.8 Payout ratio (%) 40.0 40.0 40 40
Edelweiss Professional Investor Research 39
Mindtree Ltd
Mindtree - Back on track after temporary disruption Debashish Mazumdar After wading through choppy waters post the takeover by L&T, Mindtree Research Analyst underperformed its midcap peers – EBIT margin declined to 10% in FY20 (v/s 17% [email protected] in FY15), attrition shot up to 17.5% in Q4FY20 (v/s 12.5% in Q4FY18), and the entire top management left the organisation. However, under the new leadership, Mindtree has bounced back sharply over the last few quarters. We expect CMP: INR 1680 Mindtree to deliver sustained growth led by (a) immense capabilities of the new Target price: INR 2100 management post the L&T takeover, (b) contribution of fast-growing Digital Upside: 25% business being much higher than industry’s ~30% average, (c) top client Rating: Tactical BUY (Microsoft) clocking superlative growth coupled with other clients in recovery mode, and (d) higher traction in run your-business offerings.
High exposure to large client to offer near-term hedge Mindtree has done a phenomenal job of penetrating its top client Microsoft. While
Microsoft changed its business course over the last five years, Mindtree tagged along with its top client to grow at a rapid pace. Mindtree’s revenue from Bloomberg: MTCL:IN
Microsoft reached USD242mn (22% of revenue) in FY20 as compared to USD20mn 52-week 692/1,725 (7% of revenue) in FY10. This growth momentum continued during the Covid-19 range (INR): pandemic as well due to Microsoft in growing 39% YoY in H1FY21. We believe the pandemic led online explosion has accelerated demand for Cloud and Digital Shares in issue (crore): adoption. Additionally, Mindtree has significant exposure to the fastest-growing M-cap (INR crore): 27,918 hi-tech vertical by virtue of its top client, which should benefit it in the near-to- medium term. Promoter holding (%) 67.59
Focused approach to deliver sustainable growth
Mindtree’s management has crystallised a strategy to target sustainable growth in the long term. The company has positioned itself as a business transformation partner (v/s a Digital system integrator) and has carved out a special team to bag strategic deals. The company added 218 new logos during FY16-20 with TCV wins growing 20% YoY in FY20 to USD1.2bn. In terms of client management, Mindtree was focused on mining large clients, and thus, top clients beyond Microsoft have also started witnessing traction off late. On the other hand, its target to reduce large tail of clients has paid off with the company having closed 60+ tail accounts. New management has stepped up hiring for leadership roles with an initiative to retain talent, which has resulted in significant decline in attrition over the last three quarters.
Outlook and Valuation: Recommending Tactical BUY Mindtree’s focused approach towards mining large clients will aid in reporting industry leading growth over next few years. Moreover, improvement in margins from a low base will lead to high EPS growth going forward. At CMP, the stock is trading at P/E multiple of 24/20x of FY22/23E expected earnings. We recommend ‘Tactical Buy’ with a target price of INR 2100.
INR crore FY20A FY21E FY22E FY23E Revenues (INR cr) 7764 7925 9054 10220 EBITDA (INR) cr) 1062 1354 1512 1796 EBITDA Margin (%) 13.7 17.1 16.7 17.6 Net Profit (INR cr) 631 867 962 1174 EPS (INR) 4 5 6 7 EPS Growth (%) -16.4 37.3 10.9 22.1 Date: January 8, 2020 P/E (x) 37.2 32.2 29.0 23.7 RoACE (%) 25.2 34.2 35.6 36.9 RoAE (%) 18.0 24.3 25.6 26.7
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Mindtree Ltd Financials
Income Statement (INR Cr) Balance Sheet (INR Cr) Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Total operating income 7764 7925 9054 10220 Share capital 164 165 165 165 Cost of revenues 5065 5273 5966 6634 Reserves 3520 3297 3874 4579 Gross Profit 2700 2652 3088 3586 Shareholders funds 3685 3462 4039 4744 SG&A 1637 1298 1575 1791 Minority interest 0 0 0 0 EBITDA 1062 1354 1512 1796 Borrowings 1 0 0 0 Depreciation 275 258 297 297 Trade payables 260 255 308 345 EBIT 787 1096 1215 1498 Other liabs & prov 458 533 586 644 Add: Other income 95 125 120 120 Total liabilities 4695 4740 5521 6439 Profit before tax 829 1168 1283 1566 Net block 226 230 188 166 Prov for tax 198 301 321 391 Intangible assets 591 539 539 539 Less: Other adj 0 0 0 0 Capital WIP 30 30 30 30 Reported profit 631 867 962 1174 Total fixed assets 846 799 757 735 Less: Excp.item (net) 0 0 0 0 Non current inv 874 895 1066 1273 Adjusted profit 631 867 962 1174 Cash/cash equivalent 562 843 1136 1555 Diluted shares o/s 17 17 17 17 Sundry debtors 1431 1247 1508 1728 Adjusted diluted EPS 4 5 6 7 Loans & advances 68 50 50 50 DPS (INR) 2 2 2 3 Other assets 707 680 760 835 Tax rate (%) 24 26 25 25 Total assets 4695 4740 5521 6439
Important Ratios (%) Free Cash Flow (INR Cr) Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Cost of rev. (%) 65.2 66.5 65.9 64.9 Reported profit 631 867 962 1174 SG&A exp. (%) 21.1 16.4 17.4 17.5 Add: Depreciation 275 258 297 297 Depreciation (%) 13.9 12.5 13.1 10.8 Interest (net of tax) 53 53 53 53 EBITDA margin (%) 13.7 17.1 16.7 17.6 Others 246 354 373 444 Net profit margin (%) 8.1 10.9 10.6 11.5 Less: Changes in WC -26 353 -139 -101 Revenue growth (% YoY) 10.6 2.1 14.2 12.9 Operating cash flow 974 1576 1207 1456 EBITDA growth (% YoY) -0.2 27.4 11.7 18.7 Less: Capex -125 -211 -255 -275 Adj. profit growth (%) -16.3 37.4 10.9 22.1 Free cash flow 848 1365 952 1181
Valuation Metrics Key Ratios Year to March FY20A FY21E FY22E FY23E Year to March FY20A FY21E FY22E FY23E Diluted P/E (x) 37.2 32.2 29.0 23.7 RoE (%) 18.0 24.3 25.6 26.7 Price/BV (x) 6.4 6.8 5.8 4.9 RoCE (%) 25.2 34.2 35.6 36.9 EV/EBITDA (x) 21.7 16.8 14.9 12.3 Inventory days 0.0 0.0 0.0 0.0 Dividend yield (%) 1.1 1.5 1.6 2.0 Receivable days 65.0 62.0 56.0 58.0 Payable days 17.0 18.0 17.0 18.0 Valuation Drivers Working cap (% sales) 19.7 15.7 16.5 16.8 Year to March FY20A FY21E FY22E FY23E Gross debt/equity (x) 0.0 0.0 0.0 0.0 EPS growth (%) -16.4 37.3 10.9 22.1 Net debt/equity (x) -0.2 -0.2 -0.3 -0.3 RoE (%) 18.0 24.3 25.6 26.7 Interest coverage (x) 14.9 20.8 23.0 28.4 EBITDA growth (%) -0.2 27.4 11.7 18.7 Payout ratio (%) 40.0 40.0 40 40
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Mindtree Ltd Price Charts
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Vinay Khattar Head Research [email protected]
Rating Expected to
BUY appreciate more than 15% over a 12-month period
HOLD appreciate between 5-15% over a 12-month period
REDUCE return below 5% over a 12-month period
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