IT Riding on multiple growth levers Sector Update Most Indian IT companies surprised positively by beating estimates (especially operating Q3FY2021 Results Review margins) and reporting healthy cash generation, acceleration in deal wins and a stronger deal pipeline, despite furloughs and lower billing days. Strong q-o-q revenue growth was Sector: IT Services driven by ramp-up of deals won earlier, recovery in impacted verticals, higher spends on digital transformation initiatives and spends to catch up with technological changes. Sector View: Positive The BFSI and retail verticals’ growth remained strong, while impacted verticals such as manufacturing also recovered, which indicated that customers have loosened their purse- strings. Tier-I IT packs delivered constant currency (CC) revenue growth of 2.8-5.3% q-o-q, led by Infosys (5.3% q-o-q CC), followed by TCS (4.1%), HCL Tech (3.5%), Wipro (3.4%) and Tech Mahindra (2.8%). Among mid-tier IT companies, Mastek, Persistent Systems and L&T Our coverage universe Infotech (LTI) delivered strong USD revenue growth of 8.1% q-o-q, 7.4% q-o-q and 5.8% q-o-q respectively. ERD companies (Tata Elxsi and L&T Technology) reported strong recovery in CMP Reco./ PT revenue. EBIT margin improved q-o-q for leading IT companies despite wage revisions, led Companies (Rs) View (Rs) by strong revenue growth, lower travel expenses, higher offshoring, improving utilisation and rationalisation of sub-contractor expenses. Margin expansion y-o-y was led by lower Birlasoft 243 Buy 320 travel and SG&A expenses, lower sub-contractor costs, wage hike deferrals, a hiring freeze, HCL Tech 943 Buy 1,250 and rupee depreciation. Large deal TCVs continued to remain strong on a sequential basis, especially for Infosys & LTI, up 2.3x and 6.8x. Infosys, HCL Tech, and LTTS raised revenue Infosys 1,282 Buy 1,650 growth guidance for FY2021 on account of strong deal flows/pipeline, while Wipro provided Intellect Design 444 Buy 500 marginally better-than-expected revenue growth guidance for Q4FY2021. Outlook: L&T Infotech 3,885 Buy 4,800 Expect strong growth in FY2022E, led by a rise in transformation initiatives and greater L&T Tech 2,660 Buy 3,100 outsourcing: We expect the Indian IT services sector to grow strongly in FY2022/FY2023 led Mastek 1,222 Buy 1,400 by acceleration in digital transformation program and a rising focus on higher outsourcing by global clients (indicated from recent lift, shift and transform deals by TCS, Infosys and Persistent 1,710 Buy 1,770 Wipro). Acceleration in investments on digital transformation initiatives have been driven by Tata Elxsi 2,817 Buy 2,850 (1) emergence of new operating models, (2) building operational resiliency, (3) reimagining customer experience, (4) faster adoption of cloud-related technologies at the workplace and TCS 3,074 Buy 3,590 (5) a focus on core modernisation, Further, some of large enterprises are moving to outsourcing Tech M 981 Buy 1,100 in order to save costs or invest in their core activities, which create significant opportunities for Indian IT vendors to lift (take over operations), shift (moving to a low-cost locations) and Wipro 430 Buy 510 transform (update/re-architect the legacy infrastructure, processes, applications and operations to digital technologies). Most Indian IT companies have indicated double-digit revenue growth in FY2022 on the back of a strong deal pipeline, ramp-up of large deals and higher spends on Cloud-related technologies. A hybrid working model, higher offshoring, continued lower Price chart travel costs and SG&A costs, rationalisation of sub-contractor expenses and a stable pricing environment are expected to maintain margin performance in a narrow band in the medium 180 term. However, we believe that margin performance in Q3FY2021 were at the highest level 160 and could shrink in coming quarters. Margins in coming quarters could be impacted by wage 140 revisions, aggressive hiring, inching-up of attrition rates, an increase in competitive intensity 120 and back of some expenses (travel and marketing costs) with the return of normalcy. Given 100 strong industry tailwinds (acceleration in Cloud-related spending, operational resilience 80 60 and higher offshoring) and anticipated stable margin performance in subsequent years, we maintain a Positive stance on the sector as Indian IT is well-poised to gain market share. Jun 20Jun Oct 20 Feb 21 Feb 20 Valuations: Nifty IT Nifty Set for strong growth in FY2022E: Most managements of Indian IT companies remain confident on delivering strong revenue growth in FY2022E on account of a strong demand environment, ramp-up of large deals, strong conversion of deal pipeline, availability of increasing cost- takeout initiatives and low base of FY2021. The CNX IT index has moved up ~42% in the last six months and outperformed Nifty by 24% in the same period because of faster-than-expected revenue recovery along with impressive margin performance and strong deals wins. Free-cash- flow to net income remained healthy in Q3FY2021 led by improved collection. Given continued improvement in deal TCVs, rising adoption of digital technologies, and higher offshoring, we expect strong revenue growth over the next few years with a stable margin. Though stock prices of IT companies have been trading higher than the historical average multiples, we remain positive as we expect the sector to deliver double-digit revenue growth in the coming years. We have a Buy rating for all the stocks under our coverage, but remain selective in terms of our preferred picks, eyeing companies with industry-leading revenue growth, a long runway for growth, strong business model, high return ratios, a rise in payouts and reasonable valuations. Key risks: 1) Rupee appreciation vis-à-vis US Dollar would affect earnings estimates in FY2022E/FY2023E and stock performance, 2) weaker macros including a potential for slower GDP growth in the US and Europe, and 3) delay in pipeline conversion. Leaders in Q3FY2021: Infosys, TCS, Mastek, Persistent Systems, L&T Infotech and Tata Elxsi Preferred picks: Large-cap: Infosys, HCL Tech, TechM, TCS, Wipro Mid-cap: L&T Tech, L&T Infotech, Mastek, Persistent Systems, Birlasoft, Tata Elxsi February 17, 2021 1 Sector Update Sharekhan IT universe: Q3FY2021 results q-o-q y-o-y EBITDA EBITDA Net q-o-q y-o-y q-o-q y-o-y Company name Revenue (%) (%) (Rs cr) margin profit (BPS) (BPS) (%) (%) (%) (Rs cr) Birlasoft 880.8 2.7 5.7 144.4 16.4 246.7 351.0 96.4 39.4 32.8 HCL Technologies 19,302.0 3.8 6.4 5,442.0 28.2 156.7 354.5 3,981.0 26.7 31.1 Infosys 25,927.0 5.5 12.3 7,414.0 28.6 -23.2 347.9 5,197.0 7.3 16.6 Intellect Design 382.2 2.8 19.6 97.4 25.5 149.0 2,462.5 80.3 35.6 - L&T Infotech 3,152.8 5.1 12.2 732.0 23.2 35.2 445.6 519.2 13.7 37.8 L&T Tech 1,400.7 6.6 -1.6 275.6 19.7 195.6 -44.4 186.1 12.4 -8.8 Mastek Limited 442.9 8.1 81.7 103.9 23.5 232.9 965.2 57.4 12.7 88.0 Persistent Systems 1,075.4 6.7 16.5 182.5 17.0 51.9 359.2 120.9 18.6 37.5 Tata Elxsi 477.1 10.9 12.7 143.6 30.1 265.8 785.6 104.9 32.9 39.0 TCS 42,015.0 4.7 5.4 12,207.0 29.1 36.8 177.7 8,701.0 3.2 7.2 Tech Mahindra 9,647.1 2.9 -0.1 1,895.4 19.6 147.6 345.5 1,309.8 23.0 14.3 Wipro 15,670.0 3.4 1.3 4,117.4 26.3 335.9 572.0 2,966.7 20.3 20.8 Source: Company, Sharekhan Research Our View on the coverage universe PT CMP EPS (Rs) P/E (x) Particulars Reco (Rs) (Rs) FY20 FY21E FY22E FY23E FY20 FY21E FY22E FY23E Birlasoft Buy 320 243 8.1 11.1 14.4 16.9 30.2 22.0 16.9 14.4 HCL Technologies Buy 1,250 943 40.8 49.3 52.1 56.8 23.1 19.1 18.1 16.6 Infosys Buy 1,650 1,282 39.0 45.7 52.3 58.9 32.9 28.1 24.5 21.7 Intellect Design Buy 500 444 1.2 18.4 22.2 29.7 363.9 24.1 20.0 14.9 L&T Infotech Buy 4,800 3,885 86.6 106.0 125.3 149.2 44.9 36.6 31.0 26.0 L&T Tech Buy 3,100 2,660 77.7 63.5 86.7 109.9 34.2 41.9 30.7 24.2 Mastek Buy 1,400 1,222 42.9 78.9 88.3 95.0 28.5 15.5 13.8 12.9 Persistent Systems Buy 1,770 1,710 44.4 56.8 72.5 84.1 38.5 30.1 23.6 20.3 Tata Elxsi Buy 2,850 2,817 41.1 54.8 71.4 89.0 68.5 51.4 39.4 31.6 TCS Buy 3,590 3,074 86.2 90.2 104.7 119.7 35.7 34.1 29.4 25.7 Tech Mahindra* Buy 1,100 981 45.9 52.3 56.3 66.4 21.4 18.8 17.4 14.8 Wipro Buy 510 430 16.6 18.9 20.8 22.3 25.9 22.7 20.7 19.3 Source: Company, Sharekhan Research **EPS of Tech Mahindra excludes treasury shares February 17, 2021 2 Sector Update Q3FY2021 snapshot July-September 2020 quarter Target performance Upward/ Reco./ Price Company Reason downward View (Rs.) Revenues Margins Net income Infosys Above Above Above Upward We have raised our earnings estimates for Buy 1,650 FY2021E-23E, factoring in strong Q3FY2021 results and strong deal wins.