Emphasis on digital likely to keep spending on IT services robust over the next five years

By: |
August 31, 2020 2:00 AM

Recovery is expected from FY22; despite premium valuations, further re-rating possible; Infosys is top pick.

Employees walk past a Infosys logo at Infosys Technologies Ltd. headquarters in Bangalore, India, on Friday, April 13, 2007. (File image: Bloomberg News)

The growing emphasis on digital is likely to keep spending on IT services robust over the next five years. Indian IT services firms are well-positioned to gain share in this $1-trn market, as they have realigned offerings and focus on client mining. We expect Indian IT firms to witness recovery from FY22e, along with a slight margin expansion over FY21-23e. Despite premium valuations, further rerating is likely. Infosys is our top pick.

Growth in IT services to remain strong

IT services spending is likely to remain strong, driven by structural shift in enterprise IT demand towards cloud- and AI-enabled analytics and automation. As per Gartner, while 2020/FY21 may witness a decline in discretionary IT spends, IT services spending is expected to grow at 7.3% CAGR to $1.3-trn over 2020-24.

Market share of Indian IT firms to grow

Indian IT services firms have realigned their offerings towards digital, which along with focus on client mining, has helped them win large deals from existing clients. This has helped Top-5 Indian IT services firms gain 110bps market share to 5%. With vendor consolidation expected to pick up post CoVID, further market share gains are likely.

Expect recovery from FY22

The correlation between revenue growth of Top-1,000 listed companies globally and Top-5 Indian IT firms is high at 66%. Given consensus expectation of sharp recovery in revenues of Top-1,000 firms in FY22, revenue recovery for IT companies is also likely. Infosys is best placed to deliver on growth (only company in our coverage to witness growth in FY21) and margins.

Further rerating likely

Although the Top-5 Indian firms are trading at a 24% premium to their 10-year average, we believe further rerating is possible as the sector’s valuation premium to Nifty is below its average of 12% and its earnings yield differential to 10-year bond yields at 1.5% is also below 10-year average of 1.9%. The sector’s under-ownership should also provide valuation support.

We rate IT services companies using a five-point framework, which factors in revenue momentum, margin resilience, client relationships, exposure to stressed sectors and valuation comfort. We assume coverage with BUYs on Infosys, HCL Tech, Tech M, TCS and Newgen, and Underperform on Wipro. We see low-interest rates in the US and tighter immigration norms as key risks to our call.

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