Mid Cap IT SCOPE FOR ALPHA, BUT AT THE RIGHT PRICE Date - 24 September 2020 Table of Contents 1 Mid cap IT reports healthy 1QFY21, initiate on Mindtree, Sonata 3-5 2 Top Picks & Valuation 7-8 3 Competitor Benchmarking 10-13 4 Company Section Mindtree 15-24 Sonata Software 25-34 Persistent Systems 35-44 Tata Elxsi 45-54 ANALYST KRChoksey Research Phone: +91-22-6696 5555, Fax: +91-22-6691 9576 Harit Shah, [email protected], +91-22-6696 5555 is also available on Bloomberg KRCS<GO> www.krchoksey.com Thomson Reuters, Factset and Capital IQ Mid Cap IT – Scope for alpha, but at the right price (1/3) Mid cap IT reported healthy margins on cost control, further scope in select companies; ER&D under performs • COVID-19 pressurised revenue in 1QFY21… • Revenue for most mid-sized IT firms declined 1-18% QoQ in 1QFY21 in USD terms (only Persistent reported growth), as the pandemic impacted demand across verticals, with supply side issues of transitioning to a WFH model also impacting growth. • Clearly, ER&D firms were impacted more, with the 4 companies in our sample reporting 9-15% QoQ revenue declines; vertical- specific issues for some firms (Aerospace & Defence for Cyient, Automotive for KPIT) and ER&D investments being discretionary in nature contributed to the greater revenue decline of this segment compared with IT services. • Among IT services firms, Persistent, Birlasoft and Hexaware out-performed peers, with Persistent reporting 3.1% QoQ growth in revenue, while the latter 2 companies reported smaller 1-3% QoQ revenue declines; Sonata (-17.8% QoQ) and Mindtree (-9.1% QoQ) were the under-performers, mainly owing to Travel exposure, with ex-Travel revenue flattish-to-growing. • …but margin performance, cash flow impressed; ER&D under-performs again • Profitability was impressive for most mid cap IT firms, with margin expansion ranging between 110-390bps QoQ on cost control and favourable currency; Coforge (earlier NIIT Technologies) under-performed peers, with a 238bps QoQ margin decline. • ER&D firms under-performed across-the-board, recording 150-330bps QoQ margin decline. • Cash flow was a key theme in 1QFY21, given need to conserve cash, and have leeway to invest as and when demand returns; most IT firms reported healthy operating cash flow, with Mindtree’s cash from operations at nearly 200% of EBITDA. • Stocks surge post results, increasing criticality of technology, fast tracked digital investments drive increase • Post 1QFY21 results, most mid cap IT stocks have surged 40-100%, as expectations of swift growth recovery took centerstage even among under-performing companies. • Increasing criticality of technology, fast-tracked digital investments and company-specific factors have driven stock performance. ANALYST KRChoksey Research Phone: +91-22-6696 5555, Fax: +91-22-6691 9576 Harit Shah, [email protected], +91-22-6696 5555 is also available on Bloomberg KRCS<GO> www.krchoksey.com Thomson Reuters, Factset and Capital IQ Mid Cap IT – Scope for alpha, but at the right price (2/3) Initiate Coverage on Mindtree, Sonata with ACCUMULATE ratings; good long term business outlook • Positive outlook on mid caps covered in this report; company-specific factors drive our underlying confidence • We initiate coverage on 2 companies in this report – Mindtree and Sonata Software. We expect Mindtree to see improved growth from 2QFY21 with resumption in global economic activity, continuing digital investments by client organisations, healthy growth in non-Travel verticals, top client Microsoft and large deal wins like Realogy acting as bulwarks, and margin expansion over FY21- FY23 led by revenue growth and cost management. Recent strategy refresh with focused service offerings to end-decision makers of technology with higher digital focus, and cutting long tail of clients should boost growth as well in the long-term. Key risk is client concentration (>30% revenue accounted for by top client Microsoft in 1QFY21, which will get addressed over the next 2-3 quarters). Valuation is slightly pricey at 22.0x/19.2 FY22E/FY23E EPS, respectively. We are positive on long term business prospects of the IT firm, and recommend an ACCUMULATE rating with a target price of INR 1,420. We recommend buying into any stock price correction. • We believe the worst is now behind Sonata Software, with 1QFY21 being a trough quarter owing to the severe decline in Travel revenue led by TUI. Other key verticals including ISV, Retail (Essential and Non Essential), Distribution & Manufacturing, and Commodities & Services should see growth return. Sonata enjoys healthy operating metrics, with impressive IITS EBITDA margin of >22% (better than most mid-sized IT firms), gross debt-equity ratio at a very conservative 0.1x (net cash positive), interest coverage ratio of >22x in FY20, no equity dilution since April 2001, operating cash flow well in excess of 100% of EBITDA and RoE consistently above 30% since FY15. In context of improving growth, differentiated business model with platform focus, marquee acquisitions boosting cash usage and expanding addressable market, and healthy operating metrics, we Initiate Coverage on Sonata Software with an ACCUMULATE rating and target price of INR 375. The stock currently trades at 11.9x/10.7x FY22E/FY23E EPS, respectively, which is fairly reasonable. ANALYST KRChoksey Research Phone: +91-22-6696 5555, Fax: +91-22-6691 9576 Harit Shah, [email protected], +91-22-6696 5555 is also available on Bloomberg KRCS<GO> www.krchoksey.com Thomson Reuters, Factset and Capital IQ Mid Cap IT – Scope for alpha, but at the right price (3/3) Remain positive on long term businesses of Persistent and Tata Elxsi, prefer lower prices to add further • We are enthused by the pivot made by Persistent under the earlier CEO towards managed services, annuity revenue, technology services business and large deals, driven by a realignment of service lines and verticals to effectively map client IT spend to its own portfolio of offerings. This has seen results in terms of improved revenue and margin performance over the past few quarters, no more so than in 1QFY21, a quarter when most peers reported mid single digit to double digit revenue declines. Deal wins have also been healthy, with Persistent winning a US$ 50mn deal with a leading enterprise software firm in the data virtualisation space, with growth visibility aided further by good traction in its digital banking products in the BFSI vertical, and initiatives in the Healthcare vertical. While near-term margin pressure could be seen owing to transition costs in large deals, this can be recouped with revenue growth. We expect 11.3% USD revenue CAGR over FY21-FY23E after a 9.6% growth in FY20, and , and 12.8% EPS CAGR over the period after 18.6% growth in FY20. We maintain ACCUMULATE on Persistent with an upwardly revised target price of INR 1,340, implying a target PE of 20x FY23E EPS. Persistent’s stock trades at 20.0x/18.3x FY22E/FY23E EPS, respectively at current levels. • Tata Elxsi’s stock currently trades at a P/E multiple of 23.0x/20.2x FY22E/FY23E EPS, respectively. Improving vertical mix diversification, near-term margin expansion, relevant service portfolio in fast-growing areas of IT spend such as embedded software, automotive electronics, AR/VR, OTT media and medical devices, and healthy double digit EPS growth (14% CAGR over FY21- FY23E) underpin our positive stance on the specialised IT firm. We value the stock at 22x FY23E EPS and arrive at a revised target price of INR 1,308 (INR 1,064 earlier) as we factor in FY23E earnings. We retain our ACCUMULATE rating on the stock and believe the recent 8% correction is a good opportunity for investors to add to their portfolio. ANALYST KRChoksey Research Phone: +91-22-6696 5555, Fax: +91-22-6691 9576 Harit Shah, [email protected], +91-22-6696 5555 is also available on Bloomberg KRCS<GO> www.krchoksey.com Thomson Reuters, Factset and Capital IQ Table of Contents 1 Mid cap IT reports healthy 1QFY21, initiate on Mindtree, Sonata 3-5 2 Top Picks & Valuation 7-8 3 Competitor Benchmarking 10-13 4 Company Section Mindtree 15-24 Sonata Software 25-34 Persistent Systems 35-44 Tata Elxsi 45-54 ANALYST KRChoksey Research Phone: +91-22-6696 5555, Fax: +91-22-6691 9576 Harit Shah, [email protected], +91-22-6696 5555 is also available on Bloomberg KRCS<GO> www.krchoksey.com Thomson Reuters, Factset and Capital IQ Our Top Picks and Recommendation Preferred picks: Accumulate on all, positive on long-term business outlook, Sonata attractive from valuation standpoint Stock Recommendation CMP (INR)* Target Price (INR) Upside* (%) Mindtree ACCUMULATE 1,294 1,420 9.7 Sonata Software ACCUMULATE 335 375 12.0 Persistent Systems ACCUMULATE 1,226 1,340 9.3 Tata Elxsi ACCUMULATE 1,199 1,308 9.1 Source: Company Reports, KRChoksey Research *As of 23 September 2020 ANALYST KRChoksey Research Phone: +91-22-6696 5555, Fax: +91-22-6691 9576 Harit Shah, [email protected], +91-22-6696 5555 is also available on Bloomberg KRCS<GO> www.krchoksey.com Thomson Reuters, Factset and Capital IQ Peer Valuation Tata Elxsi, Mindtree command premium valuations, Sonata awarded fair discount owing to size, Travel exposure Market Recommendati P/E (x) EV/EBITDA (x) RoE (%) Stock capitalisation on (INR Mn) FY22E FY23E FY22E FY23E FY22E FY23E Mindtree ACCUMULATE 213,722 22.0 19.2 13.6 11.8 25.2 25.9 Sonata ACCUMULATE 34,787 11.9 10.7 7.5 6.5 38.1 37.0 Software Persistent ACCUMULATE 93,430 20.0 18.3 12.3 10.9 17.0 17.6 Systems Tata Elxsi ACCUMULATE