2020: Annus Horribilis, But Not For Tech. Will That Sustain?

The key question is not whether the business of IT vendors can improve, but more about the business mix changing favourably, and whether margins can improve from here. Higher margins lead to higher profitability and return ratios, and thus higher multiples. Still, the argument for the predictability of revenues for IT companies—and therefore higher price-to-earnings multiples—has been made and dismissed multiple times over the last few years.

I suspect some re-rating due to the first argument is already underway. However, not hazarding a guess, I would try and offer some perspective on the catalysts and the pressures around business growth, margins, and valuation multiples for the near and the medium term.

Catalysts In Favour

In the near term, Indian IT companies have beaten revenue and margin estimates. Infosys, Wipro, Tech Mahindra, L&T Infotech, and Mindtree, among others, saw their margins expand sequentially in Q1FY21 led by factors like wage hike deferral, tight control on discretionary spends and lower travel costs. The commentary indicates an improvement in spending outlook and cautious optimism.

CP Gurnani of Tech Mahindra said the company’s “deal pipeline is the strongest it has been in the last three years but in our experience, in time of uncertainty, deal closures also take much longer.”

Yet, deal closures in the last few months give HCL Tech management the confidence that growth could return from Q2. Similar commentary came from other vendors, even those in the mid-cap space. So, growth is unlikely to be that big a challenge.

A senior executive from the sector told me that companies have been getting a lot of new requests for proposals in the last couple of months.

Companies, he said, are holding budgets tight for any big commitments, but $3-10 million spends are getting approved fast. So, there can be potentially good growth for those Indian IT companies that do a lot of basic work, in addition to some transformation work.

This means that the Indian IT vendors would have the near- and medium-term growth mix in place. And if growth stays put, one can safely assume that money will find its way into these stocks, keeping valuations elevated.

Since it’s now accepted that technology-led business models will emerge as more critical than ever as we reimagine the global supply chains of tomorrow, the nature of work for Indian IT vendors, and their global peers like Accenture, Cognizant and IBM, could well play a big role for every business.

Coupled with this, if clients scale back their IT departments to cut costs, that could mean more outsourcing and, thus, more revenue-mining from the same company, leading to even better margins. Mind you, I am not factoring in the work-from-home advantage on the margin front. That may be a straight pass-through.

Does the past tell us anything?

The historical numbers on the margin front are inconclusive. While the third-largest Indian IT vendor HCL Tech has scaled up EBIT margin notably over the last decade from very low levels, Infosys saw a significant pullback a few years ago, while TCS seems to have consolidated.

Despite being inconclusive, the past does point towards these companies’ ability to defend healthy EBIT margins in a decade of severe competition and pricing pressure.

There Are Pressures, Though

The larger companies have operating profit margins of 22-25%, which are good and probably one key reason why some experts sound skeptical about further margin enhancement. The argument is that while Indian IT companies are targeting a large ocean of opportunities, their priority would be getting a meaningful share of clients’ wallet, not margin expansion. In fact, chasing margins could lead to loss of business as there would be competitors willing to do the same work at lower margins. And if margins don’t expand, it’s difficult for multiples to rise.

Capabilities around products missing

Indian IT firms are not product companies. Unless service companies become product companies, which gives them pricing power, it’s unlikely the business can have large non-linear growth opportunities. We know that linear growth opportunities can only scale up margins to a limited level. Non-linear growth, with bumped up profitability, helps margins improve. On that front, notwithstanding the tremendous expertise of the IT vendors, one has to admit that they have not quite made a splash.

So Then?

The argument is that an investor should always, and particularly at times like these, give merit to what is the downside to the logic that is driving this tech rally. If margins and multiples don’t move up, would earnings growth stay strong? Even if the investor does not make much more new money, what are the chances of losing money? The answer to this would be different for each investor, but I have not seen too many instances of a GARP (growth at a reasonable price) investment going kaput. But what counts as ‘reasonable’ in such times – us it long-term average multiples of 20x, or higher, given that we are in a low-interest rate and high-liquidity world?

Betting on visible, steady, risk-free growth might just be the strategy for the medium-term as it exists now – with more uncertainties along the way than one has seen in a long time.

Niraj Shah is Markets Editor at BloombergQuint.