Buy Infosys and Mindtree - Third wave of IT outsourcing cycle ahead, says Goldman Sachs

Buy Infosys and Mindtree: Goldman Sachs has put a 12 month target price of Rs 1369 on Infosys and this implies 17% potential upside vs the sector coverage average of 4%. Goldman Sachs 12 month target price of Rs 1795 on Mindtree implies 23% potential upside vs the sector coverage average of 4%. Digitalization at scale and COVID-19’s acceleration of Work from Anywhere has boosted technology demand across industry verticals and geographies. Moreover, Goldman Sachs note that IT outsourcing has seen strong pick-ups (lasting at least two years) after previous crises (such as Y2K and the GFC). These factors support our forecast of a third wave of IT outsourcing in FY21-23E.

Goldman Sachs expects this multi-year technology upgrade cycle to have three key stages:

1) a large-scale shift to cloud
2) the building of applications in the cloud native world
3) Collaboration between IT service vendors and customers to build new technology solutions.

As a result, Goldman Sachs forecasts a sharp pick-up in FY22/23E USD revenue growth of 13.1%/9.7% for the Top-5 Indian IT vendors vs. -0.1% in FY21E and a 4.6% CAGR in FY18-21E.

Goldman Sachs forecast of double-digit USD revenue growth for the Top-5 Indian IT vendors is backed up by their macro team’s forecast for 5.3% US GDP growth in 2021 (vs. -3.5% for 2020) with a base case calling for widespread introduction of COVID-19 vaccines in first half of 2021 and increasing revenue growth for key industry verticals in 2021 (in line with our IT demand tracker). Goldman Sachs expects EBIT margins to improve in FY22E/23E led by operating leverage with double-digit USD revenue growth, a higher offshore mix, employee pyramid optimization, and an automation-first approach leading to non-linearity in revenues and lower sub-contracting costs.

Goldman Sachs value Infosys using a target P/E multiple of 24.8X (12-yr average P/E plus 3x standard Deviation given their expectations of the fastest revenue growth within large-cap coverage, as future earnings growth potential looks strong given industry tailwinds. The stock is currently trading at 22.2X FY22E P/E and FY20-23E EPS CAGR of 14.6% (vs. the Indian IT sector average of 20.4X with FY20-23E EPS CAGR of 15.4%). Goldman Sachs FY22/23E EPS estimates are 6%/5% above Bloomberg consensus estimates on higher revenue as well as margin assumptions.

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Goldman Sachs values Mindtree using an average 12-yr P/E +2x standard deviation of 22.4X (given expectation of the fastest EBIT growth within) to arrive at a P/E-based valuation of Rs 1795. The stock is currently trading at 20.0X FY22E P/E and FY20-23E EPS CAGR of 29.4% (vs. the Indian IT sector average of 20.4X with FY20-23E EPS CAGR of 15.4%). Goldman Sachs are 15%/18% ahead of Bloomberg consensus EBIT for FY22E/23E, largely on account of higher margin assumptions.