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Structural tailwinds vs Cyclical headwinds

Updated: Mar 11

Greetings from Team Carnelian!!! Hope you and your near ones are doing well.


‘Identify and follow the trends in your industry. Don’t fight against the current of change. Instead, recognise these as an opportunity and seize the advantage.’ – Becky Sheetz-Runkle


Over the last 15 months we have communicated our bullish outlook on the structural shift in the digital and manufacturing sector. Such massive shifts are a decadal opportunity and lead to massive wealth creation over the entire journey. However, the trend is never a straight line. As highlighted in our previous newsletter, a structural bull run always has a Type B risk – i.e., “the volatility risk” or “temporary MTM risk”.


Over the last 2 months, we have witnessed a decent correction in IT stocks after a sharp rally over the last 12-15 months.

While it is natural for one to be concerned by the magnitude of the correction, the key question one should address is whether the recent correction in the IT space is cyclical or structural?


To address the aforesaid question, we recently interacted with numerous IT company CEOs & industry experts. Key takeaways of our discussion are

  • Demand environment will remain robust for the next 3-5 yrs

  • Strong deal wins continue unabated

  • Pricing environment supportive though timing mismatch between price and cost increase is possible

  • War for talent/attrition will ease off

We remain fairly convinced on the continuity of the structural bull run in the digital space & view the current downturn in IT stocks as cyclical and would consider the same as an opportunity rather than threat.


Key takeaways from our interaction:


Strong demand outlook


Digital spending continues to be robust in key sectors like financials, manufacturing, retail, Hitech & telecom etc. The above is also corroborated by consistent mega deal wins flow and lifetime high order book. TCS, the largest IT services player of India has guided for a high single digit dollar denominated growth over the next 10 years - with aspiration to achieve USD 50 bn revenue by FY30 and a potential to reach the above number in next 5 years if the current growth rate continues.


Similar strength is also visible across the mid-cap IT companies’ commentary as well:

Deal Wins


What do industry experts say??


Historically, global IT spends have grown at 3% CAGR in $ terms over the last decade. Gartner, a leading IT consulting firm is expecting the growth to be 9% CAGR in $ terms over the next 5 yrs. As per NASSCOM, the Indian IT industry will grow to $350 bn in $ terms in next 5 years from $227 bn currently implying a 11.5% CAGR. Similar is the case with ISG deal flow data pointing similar optimism.


Cloud Migration/digital transformation: A massive opportunity


Migration to cloud is the first phase of digital transformation journey followed by development of various cloud applications. Companies are building massive talent capabilities to participate in the above transformation journey.


IT spending will move to Horizon 2 (Cloud Applications) and Horizon 3 (Advance cloud analytics) initiatives once a substantial part of Horizon 1 (Cloud adoption) gets completed. Companies will spend on modern applications and leverage cloud native capabilities such as advanced analytics and AI.


Margin Outlook


Return of travel expenses, slight compression on the offshore mix, high attrition are some near term headwinds to the margins. However, over medium-term margins will continue to sustain at higher levels owing to the reasons mentioned below:

  • Pricing environment is robust, and companies are getting fair share of price increase.

  • Though travel and some discretionary cost will come back but will structurally be below pre-covid levels.

  • Utilization rates will continue to be structurally higher due to remote operating model and talent fungibility.

  • Higher offshoring will sustain.

Attrition will normalise over medium term


Attrition continues to remain high, however IT companies expect the same to normalise over the next 2 quarters. This will be driven by a significant fresher intake and captive learning platforms. Most companies have already announced that they are resorting to backward integration with colleges campuses itself to reduce their onboarding period.


In 9M FY 22 – top 5 companies have added more than 2x of total hiring vis-à-vis FY21.


Demand-supply imbalance gets realigned eventually

Commentary from the leaders

Conclusion


Owing to the above we believe that the demand environment remains robust for the next 3-5 yrs. Post the initial phase of cloud adoption, enterprises will spend on modern applications and leverage cloud native capabilities such as advanced analytics and AI. We assign a very high probability of India leading the world’s digital revolution & hence continue to invest aggressively in India digital story with our Shift Strategy.We find the below mentioned quotes best suited in the current environment:

  • “The real key to make money in stocks is not to get scared out of them” - Peter Lynch

  • “Successful investing is about having people agree with you……...later” - James Grant

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