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IT emerging as growth sector, will see significant re rating: Vikas Khemani

The sector can get re-rated significantly over the next four-five years. All the leading companies as well as smaller companies will be doing very well in the sector, says the Founder, Carnelian Capital.

The market has already been assigning a premium to most IT stocks. Do you think the Covid crisis is going to lead to mega trends in the manufacturing and IT sector even for the longer haul?

Absolutely. According to us, this is just the beginning of a very big trend. Significant shifts have happened and in some sense, I feel it is more like a Y2K event which accelerated the growth in IT services. This is the second phase of that. Today whether you like it or not, whichever company you are, whatever sector you are or even the governments have to spend a lot more on IT, specifically on digitisation and cloudification. These two-three trends, apart from the newer technologies which you just talked about are trends that are here to sustain and stay.

We have seen a big change in the demand environment from the large, small and medium companies. This is not a one-year or six-month trend. It is going to stay for three-five years. And if that is the case and if we are fairly convinced about the demand, then we have to look at the cost side. There are significant upticks happening on the margin. You do not have to spend as much on SG&A. Work from home has helped savings and you can access a talent pool outside the major cities as well. Each company will have an improvement of about 300 to 350 bps of possible margin which they can pass on partly.

So on one side, the demand environment is improving. On the other side, the cost structure is getting better in the free cash flow generating companies. Their PAT gets converted into free cash flow and they do not need to raise capital. Another very interesting part about this sector is here demand is global but the supply is local and that too by a handful of companies. About 10-15 companies are supplying the global demand. Historically, in the last four-five years, IT has been seen as a more defensive, low growth sector and now we will see a significant pick up in growth in the sector. It will become a growth sector.

There will be top line growth because of the operating leverage. According to me, most companies would grow in the 15-20% profitability range and with free cash flow generation of 5- 6%, valuations are not at all demanding. The sector can get re-rated significantly from here over the next four-five years.

There was a shock value after Covid and that is going away. I feel that it is a very big trend. You will see all the leading companies as well as smaller companies doing very well in the sector.

If I look at the PE multiples of top IT companies, the PE multiples of TCS NSE -0.60 % is 20 plus, Infosys NSE 0.74 % almost 20, HCL Tech nearing 20. Where is the scope for these companies to go higher?

Very interesting point. First of all in this sector leadership might not change. The top five-six companies will get disproportionately larger share because they have built a huge amount of moat. It is a very sticky business. Once you are into the ecosystem of a customer, it is very hard to change the customer.

More importantly, all these companies are very well placed to build the capabilities which are required for a changing environment. On the digital side, a huge amount of capability has been built by TCS, Infosys, Wipro NSE 0.70 % and others. They will continue to benefit. The big change which has happened is the shift in the demand environment. When the demand environment is poor, even if you have good free cash flows, you will always be seen as a defensive sector. What has changed right now is the perception of the sector from a defensive sector to a growth sector. When this shift happens, you can go back and change history whether it was 2009 FMCG or industrials in 2003-2004. So a big change happens in the demand environment and throws open a possibility of re-rating.

Two vectors will play out over the next four-five years. One is that these companies will grow their earnings between 15% and 20%. Smaller companies probably can grow even 30-35% because of the base effect. Thus the earnings growth will be captured but invariably a significant re-rating will happen. I would not be surprised if most of these companies in a couple of years’ time trade at 35-40 PEs not unlike what has happened in case of FMCGs.

From a capability standpoint, most of our IT companies are doing transformative work. It is wrong to assume that they are doing some sort of cost arbitrage. Hence there will be a four-five year period of significant growth which will eventually lead to re-rating because none of these companies need to raise capital.

If the dollar does not weaken, what happens? Lots of IT companies have benefited on the margin front because of weakness in rupee or because of strength in dollar. 

It is a very valid point but to counter that, each of these companies have savings between 300 and 300 bps on the cost aspect. Today with the work from home culture, they can access a talent pool which is remotely available. The cost of that talent pool will go down. You are no longer spending money or selling, general and administrative expenses that you used to spend before. There are lots of levers and I have always believed fundamentally if the demand environment is strong, margin will never be a problem. So assuming that the currency appreciates, I am sure there will be a lot of levers for these companies to manage that margin. Even if they maintain their margin profile, most of the companies will still come out very pretty.

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