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Growth coming back to Indian IT firms as US businesses hiked spending, says Morgan Stanley

Growth coming back to Indian IT firms as US businesses hiked spending, says Morgan Stanley

Growth coming back to Indian IT firms as US businesses hiked spending, says Morgan Stanley
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By Nimesh Shah  Jun 8, 2018 6:49:38 PM IST (Updated)

Growth is coming back to Indian information technology companies as US businesses hiked spending, said Parag Gupta, India TMT Analyst, Morgan Stanley.

Growth is coming back to Indian information technology companies as US businesses hiked spending, said Parag Gupta, India TMT Analyst, Morgan Stanley.

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Speaking to CNBC-TV18, he said he is positive on both largecaps and midcaps as latter is growing at a much faster rate.
Gupta said companies that are delivering growth, both on revenue and on earnings, are basically trading at premium multiples.
Edited excerpts:
You track whole host of sectors – telecom, media, information technology. I will start with information technology (IT) first, because that is where lot of interest is right now within the investors as well. What is your broad sense on IT right now? Q4 was pretty strong, the commentary was strong and even the stock prices have delivered. What is your general view on IT now? Are you still overweight?
We had upgraded our view on the sector to an attractive rating early this year and we believe that there are various factors that are basically coming into play, which are positive for the industry and mostly everyone that is participating in that. One is that there are significant amount of spends that are coming in from customers. I think there was a little bit of a pullback in spending in 2017 and prior to that. To some extent, you could allude that to may be the US elections and customers not being sure about what is going to happen in the new administration. I think some of those fears have now gone away.
The second, we are all talking about new technologies and I am sure even customers are not sure about which technology they want to adopt. As a result of that, the spending was a lot lesser. A lot of it was proof of concept, so the deal sizes were smaller, the contract duration was much shorter and as a result of that, companies didn’t have visibility on how revenues will shape up over 12 month period. Now, what we are beginning to see and that was our call at the beginning of the year is that we are now at a situation, where global growth is picking up – that provides significant lever to customers to spend because they are a lot more comfortable with how their own business prospects are looking and when business is picking up you generally want to spend more on technology because it gives you better efficiencies, better productivity and plus there are lot of spends that you have not done. So, there is a little bit of a catch up that comes into play.
The third thing that happened is that these digital deals that we are talking about, which were much smaller and proof of concept started scaling up. We saw a couple of large digital deals being announced. Here, large may not be multi-million dollar deals like $300-400 million deals but these were more like $40-50 million deals, which basically means that the adoption of digital is actually getting broader and deeper.
The fourth is that we are actually seeing customers in the US beginning to spend. Probably, some of that was related to the new US tax laws that gave companies better cash flows, better earnings and hence more investments in information technology. Now, that obviously all bodes well, if you put them all together for the technology providers.
Now, the question is that, would the Indian vendors benefit or now. We believe that this is definitely a much better situation to be in than what it was same time last year. I think, the companies have relationships with their customers. So they can leverage that to get more projects. They are investing into the new digital technologies that we are talking about. So, that is probably bearing fruit and as you see growth is coming back in, there is a momentum that builds up and what we have generally seen in the sector is that when momentum comes in, it actually starts percolating across the entire company itself.
Talk about the disruption in the IT space. Lots been talked about with the new technology, with the disruptions. There could be a bit of a shake out. Will that be an opportunity for Indian companies or will that be a bit of a risk for the Indian companies?
At this point of time, it’s both a risk and an opportunity. It’s a risk because these are technologies that are getting adopted. You may not necessarily have the skill sets existing within the company, so a lot of new investments need to be made.
The second risk that comes along with this is that, customers themselves are kind of working on this on a daily basis. So, a lot of work that needs to get delivered happens onsite as against traditional work, where a large part of it was being delivered offshore. The risk out there is you need to build an onsite team. So you need to get those people in place and it kind of alters your cost structures. So you need to think about how you are going to manage both of that.
The third is that you need to have necessary domain expertise because everyone in the business today is fighting for new technologies, because what we call new today will eventually become mainstream in the next couple of years. So, it's definitely a risk from that perspective. Why is it an opportunity? The simple reason is that all customers want to change the way they operate. Everyone wants to have an app, everyone wants to become a lot more customer friendly. So your user interface, your integration of front end with back end has to completely change. It's a complete uberisation of systems that everyone talks about, which means that systems have to become so customer friendly, that you will definitely need a technology provider, who can come in with all the necessary expertise to provide that. So that is the opportunity. Incrementally, a lot of spending is transferred to run the business, which is traditional into the new business, which has changed the business. So, it’s an opportunity and if you are not there, you are not going to see incremental growth rates coming your way.
You upgraded the whole sector at the beginning of the year and you saw this coming and that got played out in the stocks as well. So many of these midcap IT names have rallied pretty hard since the beginning of the year. Many of them from a valuation point of view have become a little expensive compared to the largecap names. How are you positioned in the largecaps and the midcaps and is there valuation concern especially in the midcap IT names right now?
I would say that yes, we have been positive on both largecaps and midcaps. I think the big difference between the two was that, midcaps were growing at a much faster rate; they have double digit revenue growth, margins are actually now potentially and going forward will be helped by rupee depreciation. So your margins have a cushion and if growth comes in your margins, get that additional cushion as well.
Was that something you found out in the commentary as well in Q4 for most of the midcap IT names?
I think the commentary has been extremely positive. None of the companies that we are talking is not talking about any potential impediments to grow at least in the near term. One obviously has to keep monitoring this, because it all depends eventually on customers. Midcaps do have a higher concentration with the few clients. So if something goes wrong with a few of these customers, obviously, it kind of percolates down much more quickly for a midcap than for a largecap.
Has that led to a bit of change in the model of your earnings expectations and FY19 for midcap IT names because I believe the largecap names like TCS, Infosys has delivered as to what they have said but the larger risk comes in the midcap and smallcap when it comes to earnings, has that been priced in that good commentary will be seen in terms of the numbers of FY19 for midcap IT?
I would put it this way. Companies that are delivering growth, both on revenue and on earnings, better than expectations are basically trading at premium multiples. That is what has happened for midcaps. They have been doing much better than the largercaps and as a result of that, the market has rewarded them with a better multiple. Is it getting to a stage where it is becoming unsustainable? I would say that maybe, we are not there yet and the reason why I say that is, because in our models today, our earnings are basically building in a rupee at 65 to a dollar, you build that in, automatically earnings go up.
Like a one percent change in the rupee adds about 20-30 bps to margins and here, we are talking about the rupee depreciation of almost close to 2-3%. So, I think that is a big change that can still come into earnings and with the commentary that we are hearing from the midcaps, we are still talking about strong growth that can be expected in fiscal 2019, but having said that there are select largecap stocks as well which looked very interesting at this point in time. They obviously benefit from the fact that they are less dependent on just a few customers and if their growth were to inflect, I think it can result in better re-rating in price-earnings multiples.
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