IT stocks have skyrocketed: Should you pop them off?

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IT stocks have become hyperactive nowadays. But isn’t the world increasingly getting more hyper-connected, hyper-automated, and super-personalised? Over the last few months, midcap IT companies have rallied ferociously. And as a result, in many cases, the valuations of midcap IT companies have become more expensive vis-à-vis those of their large-cap peers.

On this backdrop, we decided to review Q1FY22 results of IT companies declared so far.

Engineering and R&D, life sciences, and hi-tech verticals have witnessed impressive growth this quarter. Cloud migration and digital transformation deals also recorded strong growth.

A healthy pipeline of deals and a sharp recovery in the key markets such as the US and Europe bode well for Indian IT companies.

The management commentaries have been upbeat and guidance for the rest of the year remains strong. The leading IT companies are guiding for double-digit growth in FY22 and are expected to maintain margins in their existing range.

Infosys, India’s bellwether for the IT sector, continued to witness a significant market share gain in the area of digital transformation. Infosys has raised its constant currency revenue guidance for FY22 from ‘12%-14%’ to ‘14%-16%’. While the numbers are often discussed in detail, investors tend to overlook the qualitative factors. Thus, we thought of focusing on them.

We have been noticing an interesting trend nowadays. Indian IT companies have been increasingly striking deals pertaining to various sustainability initiatives of their clients.

For instance, a pharma major in the US appointed TCS to drive its energy savings initiative at 8,300 stores and 31 warehouses. With this effort, the company is aiming to reduce its CO2 emissions by 70,000 tonnes. And that’s not a one-off.

A Japanese power generation company selected TCS for their plant automation and maintenance work. The company has been working on reducing emissions. Similarly, an American gas and electricity company chose TCS to develop applications for better prevention and emergency response to wildfire events.

Consistent recovery in the key automotive markets helped companies such as L&T Technology Services (LTTS) and Tata Elxsi secure new orders from the EV space.

Developing a large-scale EV ecosystem is a vital piece of a sustainable future. IT companies are now identifying new growth areas and also recalibrating strategies to capture growth opportunities in the verticals where they are already present.

LTTS has identified ‘sustainability’ as one of the 6 key strategic investment areas to scale and strengthen its technological capabilities. The other areas are 5-G, Electric Autonomous and Connected Vehicle (EACV), med-tech, digital manufacturing and AI&ML driven smart offerings. The stock has rallied 17% in July alone.

HCL Tech has created a new ‘Industry Software Group’ which endeavors to focus on building next-generation products in 5G, telecom and enterprise AI. Moreover, the company has identified ‘new frontier countries’— South Korea, Vietnam, Taiwan, Mexico, Brazil, Spain, and Portugal—to drive growth over the medium term. According to the company management, the strong economic growth potential of these countries and accelerated digital adoption would be the key drivers.

Large companies have been diversifying across industries and contract values to reduce the concentration risks. Going forward, M&A may emerge as a high-potential growth area for IT companies. Businesses are inclined to engage IT companies to harmonize and integrate acquired businesses.

Enhancing customer experience has been another focus area for Indian IT companies. For instance, customer success and data intelligence contributed 40% and 15% respectively to the top line of Mindtree in Q1FY22.

Interestingly, the travel revenue of Mindtree recovered significantly in the June quarter and stood just 10% below the pre-pandemic levels. Travel, transportation and hospitality sector contributes 13% to Mindtree’s top line.

Similarly, Tata Elxsi secured a contract from a leading healthcare provider for the development of a next-generation digital health platform. It also cracked a deal with a US-based broadcaster for the development of its global OTT platform.

Are IT majors going to call their employees back to the office soon?

HCL Tech is aiming to get 100% of its workforce vaccinated by the end of Q2FY21. So is TCS. As disclosed by the TCS management, 70% of their employees and associates have been vaccinated at least with one shot so far. For Infosys, this number is approximately 58%.

WFH (Work From Home) environment helped IT companies optimise lots of costs.

It appears that Indian IT companies are likely to allow their employees more flexibility—with regards to whether they want to work from office or opt for WFH, post pandemic. Employee preference, customer expectations and the nature of products/services they are working on will be the deciding factors. These developments should be tracked closely as they directly impact margins.

In summary

Many leading IT companies are sitting on multi-year high accumulated contract values. A few others have the best-ever deal pipeline. As a result, the frontline IT companies are enjoying a strong growth momentum and greater earnings visibility. Current valuations of these companies are expensive as compared to their historic valuations. But in the last 10-15 years, the investment cycle has also not been as strong as it currently is.

Let’s not forget, IT isn’t a capital-intensive sector and leading Indian IT companies generate huge free cash flows. If ‘digital’ is the future, IT companies are likely to enjoy the spotlight in the foreseeable future. Don’t be greedy but don’t sell out too early either. Be stock-specific.

(The writer is head of research at Ventura Securities; views expressed are personal)