Infosys, HCL Tech and Tech Mahindra are top bets: CLSA on IT sector

Top CLSA bets - Infosys, HCL Tech and Tech Mahindra: Market share gains to drive revenue growth momentum in CY21. The Indian IT sector should continue to outperform the broader market in 2021. While accelerated digital/cloud adoption is a strong medium-term narrative, CLSA expects market share gains through cost take-out/vendor consolidation deals to be key drivers of sector earnings upgrades in the near-term. 5G rollout and demand recovery in the ‘troubled’ verticals could provide incremental upside. Normalisation of execution costs may pose margin headwinds, but CLSA sees limited risk of a sharp downside.

Revenue-led EPS upgrades, while numerically lower than margin-led increases (seen in second half of CY20), could keep valuations elevated in the sector. Healthy FCF yields (for select stocks) and underweight positions of most institutional investors versus benchmark indices also lend support. Infosys, HCL, and Tech Mahindra (TechM) remain their preferred picks to play the 2021 themes.

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Infosys trigger: revenue growth sustaining ahead of TCS, 

HCL Tech trigger: revenue acceleration and/or higher capital return and 

Tech Mahindra trigger: improved capital return and 5G play.

Accelerated cloud adoption is a key medium-term demand driver:

Accelerated demand for migrating workloads (storage/processing) from on-premise/ private cloud to public cloud should remain a key revenue growth driver for IT services companies. The managed cloud services market is expected to show 16% CAGR over CY20-23 to US $90 bn by 2023, ahead of 2.6% Cagr projected for overall IT services. Most players are positioned well to play this multi-year opportunity. For example, TCS has created five specific groups for each cloud hyper-scaler (such as Google Cloud, Azure and Amazon Web Services) for a broad-based footprint. This is important as every US $1 spent with a cloud hyper-scaler generates US $3.5 for the services ecosystem.

5G and recovery in troubled verticals could give incremental upside:

CLSA estimates a US $13 bn potential market opportunity for Indian IT companies from 5Grelated IT spend by telecom service providers over CY20-25, assuming a phased capex cycle and conservative software component/offshore adoption (see 5G for growth). Further, demand should recover in verticals affected most by Covid-19 (ie, Energy, Travel and Hospitality, 20% of industry revenues) with improved vaccination coverage.

Downside risk to margins is limited:

CLSA suspects incremental margin expansion in 2021 will be constrained by normalisation in execution costs: FY21 wage hikes are being rolled-out in 3Q/4QFY21; travel cost should come back, at least partially, over 2021; and transition costs in large deal wins could be a substantial drag if routed through P&L.

Cash is king:

The combined FCF for the top 5 players in the first half of FY21 alone was over 80% of FY20. Given the liberal commentaries/increased allocation, we expect capital return to improve in 2021. TCS and Wipro have already announced buybacks; CLSA expects others to follow.