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Carnelian Update – Digital Revolution

Updated: Feb 4, 2022

Dear Carnelian Family,

Hope everyone is safe and fine at your end.

In our last newsletter, we have briefly touched upon the IT industry as being one of the structural opportunities providing a dual opportunity of superior earnings compounding along with P/E re-rating - a perfect ingredient for our magic basket.

Since then our research team has been consistently testing the above hypothesis which involved interaction with various industry experts and leaders. Few of the findings which excite us are produced below:

IT companies (top 10) demonstrate a post tax ROIC of 55% & FCF to PAT of 90% available at an attractive dividend yield of 3.2%.

On the growth side we are overwhelmed by the evidence supporting our hypothesis which include the recent multi-billion dollar deal wins, global digital adoption at a faster pace coupled with the unique position of Indian IT/ITES to be a world supplier of digital revolution.

Few of the recent comments from industry leaders which enthused us are:

1. TCS is going to make their digital contextual knowledge capability 5 times. Cloud is the new ERP – Rajesh Gopinathan

2. Satya Nadella: We have seen two years’ worth of digital transformation in two months

We foresee a ~USD 90 bn digital opportunity flowing to Indian IT players over the next 3-5 years. The first wave will be cloud migration followed by development of various applications/products for the new cloud environment. Indian IT Inc. are also best positioned to capture the emerging inorganic growth opportunity – Big will become bigger. Indian IT players are also uniquely positioned to capture a plethora of opportunities into the ER&D space. We foresee a ~USD 30 bn of opportunity for the Indian IT ER&D players over next 6 years.

Considering all of the above, we are convinced that we are at the cusp of the 4th wave of IT sector growth and hence have increased our weight of IT sector to 20%.

Satya Nadella (CEO of Microsoft) said a few months ago – “We’ve seen two years’ worth of digital transformation in two months. From remote teamwork and learning, to sales and customer service, to critical cloud infrastructure and security—we are working alongside customers every day to help them adapt and stay open for business in a world of remote everything.”

Closer home, Rajesh Gopinathan (CEO of TCS) also recently made an interesting comment on air when he said that “We are at the cusp of a significant growth phase for the industry”. HCL Tech has revised their guidance for revenues and margins upwards while Infosys has signed its biggest ever deal in the history of the company.

All in all, we believe that we are at the beginning of the 4th wave of growth for the Indian IT sector.

While digital was an already rapidly growing segment over the last few years at a 20% CAGR, seeing the latest jump in US e-commerce trends, shift towards internet banking, surge of subscription of OTT platforms etc., there are various global demand triggers as companies all over the world realize the importance of digitalization across sectors.

Some key trends are:

a) Digital spends are shifting from discretionary to non-discretionary as companies realise its growing importance to sustain/survive

b) Companies are taking a longer term view by believing that current spends on digital will be recouped by cost efficiencies or growth in the near future

c) IT spends shifting from legacy capex (investments in physical infrastructure) spends to cloud based opex spends which is driving a big growth in cloud – Rajesh Gopinathan (CEO of TCS) recently said that “Cloud is the new ERP”.

d) Another emerging trend having a strong growth potential, apart from digital and cloud is the ER&D space where there is a shift from mechanical services to embedded services alongwith a role in the entire product life cycle which is likely to spur growth and increase TCV in this segment.

Although the demand is global, we believe Indian IT companies are best placed to capture these industry tailwinds due to the ability to weather all previous cycles and also the ability of Indian IT companies to foresee structural trends and be ahead of the curve. Today all Indian IT companies have capabilities in the future growth areas of digital, cloud and ER&D which are all likely to see accelerated growth over the next few years.

With growth expected to be robust and broad based, we also expect margins of IT companies to improve by ~200-300 bps over the next 3-5 years due to:

a) Stable wages at bottom of pyramid (freshers) for over a decade

b) Virtual training capabilities will lead to lower skilling costs

c) Work from anywhere to widen existing labour arbitrage and increase offshoring

d) Work from anywhere to result in significant SG&A savings (rent, travel, other office overheads, etc.)

TCS’ SBWS (secure borderless work spaces) – “Believe that by 2025, only 25% of associates will need to work out of facilities at any point of time; and will be able to realize their potential without spending more than 25% of their time in a TCS office”

Indian IT companies already have strong Balance Sheets and can take advantage of any structural growth drivers without meaningful incremental capex.

We foresee robust growth prospects, structural margin levers combined with great Balance Sheets and outperformance on ESG scores. Low free float availability (~57% is the market cap weighted promoter holding for the Top 10 IT companies) which may reduce further due to buybacks, alongwith bright prospects, are making it a “magic” story in the making and a prime candidate for re-rating.


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