June 2021 Sector Report IT Services f cus Techolution: A small (cap) step for Change, A giant leap for Value Sandip Agarwal Pranav Kshatriya +91 22 6623 3474 +91 22 4040 7495 Sandip.Agarwal@edelweissfin.com Pranav.Kshatriya@edelweissfin.com Nikhil Choudhary Ayur Bohra Nikhil.choudhary@edelweissfin.com Ayur.bohra@edelweissfin.com Edelweiss Securities Limited IT Contents Executive Summary ........................................................................................ 2 Small (cap) step Change, giant Value leap ..................................................... 5 Methodology to find compounding businesses ............................................. 8 5 Golden rules of turnaround and USD600mn-900mn revenue band ........... 8 Above methodology and framework have consistently worked ................... 9 Outlook & valuations .................................................................................... 14 Initiating Coverage Birlasoft ........................................................................................................ 17 Coforge ......................................................................................................... 45 Firstsource Solutions .................................................................................... 72 Edelweiss Research is also available on www.edelweissresearch.com, Bloomberg - EDEL, Thomson Reuters, and Factset Edelweiss Securities Limited IT Executive Summary Though our IT services team may appear lethargic (just three initiations in previous decade--LTI, LTTS and Mindtree), it’s pertinent to note that the team is methodology- (DNA research) and framework-driven while initiating coverage on technology companies. The IT industry, and a tough entrepreneurial experience, have taught us why none of the Indian mid-cap companies, barring a few, have transitioned to large caps in the past two decades. The margin differential between large-, mid- and small-cap Indian IT services companies sums up the whole story. The difficulties of transition are compounded by: (1) tier 1 versus tier 2 clients, which are characterised by low pricing & less annuity and are more project based; (2) higher pay for similar talent; (3) high attrition; and most importantly, (4) the USD1bn invisible footnote in all deals, restricting most of them from participating in large deals/clients. Transition from Mario to Super Mario: 5 Golden rules of turnaround So how does one break free from this vicious circle? The answer is brand power-- build a credible brand (one could also take the easier way out by either acquiring one or getting acquired itself like Mindtree, Coforge, L&T Infotech, LTTS). This will, at the outset, address employee-related issues (acquisition, retention and cost). The next step is to harness the brand, its contacts and balance sheet to lure industry talent and clients. Once the company’s credentials are cemented, it then needs to adhere to what we call the “5 Golden rules of a turnaround”--Fearless team, Meritocracy, Large deal experts, Clean up tail accounts and New avenues of growth (refer to table 12). Tech upcycle assumption: Key catalyst to our thesis All great turnaround stories in the past like TCS, HCL, Tech M (10–16x over FY09–16) were buoyed by industry tailwinds (IMS). To put it mathematically, a higher proportion of digital (almost 40%) than IMS (~10% in FY09, driver of the previous technology cycle from FY09–16) implies multi-bagger returns, this time as well. Caveat emptor…bear in mind We stand by our “Techolution” thesis. And, at the risk of repetition, we say it loud and clear--the technology upcycle has just begun. That said, an almost vertical up move (IT stocks have rallied 173% on average since the beginning of FY21) implies there could be periods of time correction (no stock price actions) and/or small downswings led by industry-specific/company-specific risks (top brass attrition, currency, etc.). Methodology: DNA research & 5 Golden rules We initiate on a company only when it fulfils all the “5 Golden rules of turnaround” and it may take 12-36 months before we complete our DNA research on a company (non- accounting/annual report). Our research entails thorough due diligence and research on the qualitative aspects of a company after it has ticked all the boxes of our turnaround framework. Our research focusses on leadership, capability, clients, incentive structure, culture, HR policies, business vision, among many other aspects. 2 Edelweiss Research is also available on www.edelweissresearch.com, Bloomberg - EDEL, Thomson Reuters, and Factset Edelweiss Securities Limited IT Above methodology and framework have consistently worked The purpose of this note is not to tom tom our past success on initiations, but to highlight efficacy of the above methodology, which we believe is a vital tool to identify mid-size compounding technology services businesses. True, the number of our initiations in the previous decade is limited to only three--LTTS and L&T Infotech in February 2018 at INR1,412 and INR1,436, respectively, and Mindtree in September 2019 at INR670. However, it’s pertinent to note that Mindtree, LTI and LTTS have jumped ~250%, 175% and 90%, respectively, since then. As is our practice, we followed the process diligently, did thorough DNA research and then waited for the companies to tick all the “5 Golden rules of turnaround”. This entire process was long drawn and has extracted its pound of flesh—it cost us dearly as we missed out early returns on LTTS & LTI and a huge 6x miss in case of Coforge. Our new ideas and conviction that will transition to large caps In this report, we are initiating coverage on Birlasoft, Coforge and Firstsource Solutions. Our detailed DNA research on the three companies over the past several months indicates they tick our “5 Golden rules of turnaround”. They are available at a discount to their mid-cap peers on Q2FY23E (12 months) earnings with a 28- 39% EPS CAGR over FY20-23E. Recommendations: Love large caps, embrace new ideas as well We can’t say it enough—this is the best phase of the “Squeeze-up cycle“ and it will prove to be immensely gainful for all players, regardless of their size. We believe digital and cloud adoption—the two big themes—should be the focus areas for investors. Among large caps, we recommend HCL Tech, Infosys and TCS to piggyback the above mentioned themes. Among mid-caps, we believe Mindtree and L&T Infotech might well be the large caps of 2035 (perhaps much like Infosys and TCS, respectively). In this report, we introduce three new compounding stories— Birlasoft, Coforge and Firstsource Solutions—with three industry themes of hyper scalers, digital disruption across the IT services industry and digital transformation of the BPM industry to technology giving India substantial advantage (refer to exhibit 4). Birlasoft: The untold turnaround (Target Price: INR551) Birlasoft appointed Mr. Dharmender Kapoor (DK) as CEO (promoted from COO) in June 2019 post Mr. Anjan Lahiri’s exit. DK has over 30 years of experience in the IT industry with cloud-related patents to his credit. He and the management has: (a) hired all business heads from tier-1 companies and posted them in client markets; (b) promoted meritocracy at the cost of unpopularity and against industry norms; (c) roped-in large deal experts—CEOs/CIOs; (d) strengthened relations with Microsoft/AWS etc; and (e) its biggest perceived negative of higher SAP concentration is now its biggest positive. We initiate coverage on Birlasoft with ‘BUY’ recommendation and ‘Sector Outperformer’ rating. Our target price of INR551 is based on 25x Q2FY23E EPS. Top brass attrition, slower industry growth, currency, among others, remain key risks. Edelweiss Research is also available on www.edelweissresearch.com, Bloomberg - EDEL, Thomson Reuters, and Factset Edelweiss Securities Limited 3 IT Firstsource Solutions: BPM transition to digital (Target Price: INR202) The global BPM industry accounts for mere 13-14% (USD200bn) of global IT spends (USD1.5tn) and global sourcing is 40-45% versus 70%+ for IT services. Digital execution puts India back in the global game. Moreover, FSOL has hired several senior executives (COO, Chief Digital Officer, 2 Presidents and 2 business heads) since appointment of Mr. Vipul Khanna as MD & CEO in August 2019. The company has witnessed substantial improvement in growth and margins since the new team has taken charge. The company has strengthened its digital solutions spanning Analytics & AI, Intelligent Automation (IA) and Customer Experience. We initiate on FSOL with ‘BUY’ recommendation and ‘Sector Outperformer’ rating. Our target price of INR202 is based on 20x Q2FY23E EPS. Top brass attrition, slower industry growth, currency, among others, remain key risks. Coforge: A digital roar to compounding (Target Price: INR5,005) Mr. Sudhir Singh joined Coforge in May 2017 and effected swift radical changes. He built a team of ‘tigers’ linking their incentives to performance, hiring large-deal consultants, cleaning tail accounts, and propelling the proportion of digital revenue from 21% to 37% over FY17–21. He is also carving out new growth verticals. The transition from a laggard to leader is powered by a jump in USD revenue CAGR from 2.9% in FY14–17 to 12.2% (ex-GIS hive-off) in FY17–21. Moreover, platforms like Duckcreek, which has similar business models as AdvantageGo, trade at EV/sales multiple of 20-25x. This implies USD800mn value for AdvantageGo alone. Initiate with ‘BUY’ recommendation and ‘Sector Outperformer’