I see the same process that happened to consumer stocks between 2009 and 2014 getting repeated in case of IT services companies and the re-rating and growth combination playing out over the next three-four years, says Vikas Khemani, Founder, Carnelian Capital Advisors.
We have seen key large deal wins since the month of July primarily with the largecaps like Infosys, TCS, as well as Wipro. How are you reading into this momentum?
It is pretty much similar to the conversation that we had a couple of months ago about three months ago. There is a strong tailwind for the IT sector which has a significant change post pandemic. Every company in the world whether you are in financial services or chemical or any other across industries across the world companies are trying to figure out how to conduct business in a new normal and that has accelerated and created a demand for digital migration, cloud migration and hell lot of technologies right.
The need for technology has gone up multi-fold and we have a sector which is basically catered to by the Indian IT services companies. This is one sector where Indian companies have almost no global competition; delivery happens from India and within that also there are limited 10-15 meaningful companies who could cater to this demand. I see that the demand environment is going to remain very robust while the competitive intensity is very low. Whenever the demand environment is robust, competitive intensity is very low and one has better margin and better returns and moreover this sector does not need a lot of capital to be deployed.
Over the next three-four years, this environment is going to remain like this and more and more people will get convinced about it. As companies deliver quarter after quarter, they get more orders and get re-rated. This sector does not need to raise capital and in fact it throws out capital. You have to buy within the same amount of stock available.
According to me, this process would lead to a significant rerating of the sector. Over the next three to four years, I see the IT sector remaining as one of the star performers for the Indian capital market. That is how we are reading it and I see very little risk to this hypothesis at this point in time.
ET Now: In which verticals do you see most of the deal wins coming in?
Vikas Khemani: The need for technology is pretty much across the board. Financial services companies are trying to reorient the way to do good business in the new normal. If you go to a manufacturing company, they are spending it in a different way. You know how to automatise more, how to make it more future focussed. The need for IT spend is pretty much across the sector. Of course, large sectors like financial services, manufacturing and even within the technology space, companies are going to spend more money. You will see spending across the board and in this process, all the large companies as well as mid-sized companies will benefit. The large companies would focus on the larger deal wins and in this process we will see some smaller midsized companies also becoming large over next three-five years.
We will see smaller companies becoming bigger and bigger companies continuing to show double digit growth. We are in a very interesting phase of growth and the deal win momentum will get bigger with every quarter. At some point in time, the Indian companies will struggle to keep the pace with the momentum. We are sensing this based on the interaction with various participants and this will in fact be very good for some smaller companies who can see a lot of demand lying around and will go and capture it.
TCS has said that the double digit growth is going to be a reality and achievable for the IT industry, Accenture has reinforced the same opinion. Do you see double digit growth as a reality for the next two years?
When such a large credible players are saying it, their opinion matters much more than mine. But having said that, I see no reason why this will not be achieved. Please let us understand that this transition or migration was anyway happening in technology from from digital cloud migration but the pandemic has brought what would have happened over the next 10 years to next four-five years. This has suddenly created a big demand and hence I am saying that probably over next four-five years, we will see a very robust demand environment for IT services.
I strongly believe that a very large part of the portfolio should be dedicated to IT services because risk rewards are fairly good in this sector. The shocks to the downside remains pretty limited so you will have a low volatility and a very decent return. It is more like a consumer kind of sector at this point in time and we are playing this through a significant overweight. I see double digit environment as pretty much a reality over the next 3-5 years.
Do you see cloud becoming a key growth component and driver going forward for the Indian IT industry?
It is. A lot of companies have been working or getting contracts or deals for cloud migration. Companies like Microsoft sell their own product but the adoption or implementation has to be done by the IT services company in India. In fact, a lot of growth from IT services is very much aligned to how much cloud capacity is being sold by the Amazons and the Microsofts under their respective products. They have been growing at 30-35% over the last couple of years and that has been more so in this pandemic. That means Indian IT services companies have had to implement it and their growth will be linked to that. So, cloud migration is a really big theme and we will see a massive tailwind over the next many years.
Every company, whether it is large, mid or small, will be forced to look at cloud solutions because of not only cost savings but also a lot of other added benefits in terms of getting better customer experience and so on and so forth. So this is the trend which is here to stay.
The new COVID strain has possibly extended work from home. We are anticipating some amount of turbulence in the UK at the moment. What is the implication for the IT industry?
When I am making the point that the environment looks very good, it does not mean that everything is hunky-dory. There will be challenges along the way. There will be corrections. But this is a trend which cannot be stopped. This is a trend which by any reason it cannot be reversed. It might slow down for some reason or other. Let us say for some reason there is a second phase of lockdown; that does not mean that we are going to go back to the March situation all over again. Most of us now know how to operate within a lockdown situation.
So in fact that can only accelerate the IT spend trend. So if any such news comes and because of that there is a correction in the IT services stocks which happened recently, one should use that as an opportunity rather than getting worried about it.
On the valuation front, are all the positives priced in? Are we looking at a further re-rating going forward?
So let me make you another very bold statement. Some time back, I had said not only would earnings grow but significant re-rating would happen in the IT services stocks. Over the next two-three years, most IT services companies will trade in the range of 35 to 40 PE for a simple reason – these companies do not need to raise capital. They in fact threw out capital via buybacks and the floating stock available for these companies is very limited and keep reducing.
On the top of it there is an environment where profits are very robust and they are throwing cash flows. More and more people will get convinced and more and more people will have to buy from the very limited stocks available from the IT services companies. This will lead to re-rating. It is a very simple process. Whenever there is a sector with limited capital requirement and a strong demand outlook or profitability growth outlook, it does well over a period of three-four years. Re-rating is a given.
The process of getting re-rated will accelerate over next three-four years. Just think of what happened in last quarter or this quarter. IT stocks are up almost 20-25% but earnings have not grown by 20-25%. In this period more people have got convinced and hence the valuation has expanded. Same thing will happen for the next 2-4 quarters. As more people get convinced, more people will buy and this is the natural process for any sector getting re-rated.
One should not worry about valuation at this point in time. These are far away from being expensive. IT services stocks are reasonably priced, compared with consumer stocks which today also show a similar 10-11% volume growth but trade at 70-80 times PE! So on a relative basis also, they are not sort of expensive. I see the same process that happened to consumer stocks between 2009 and 2014 getting repeated in case of IT services companies and the re-rating and growth combination playing out over the next three-four years.