HDFC Securities continue to maintain their positive outlook on the sector, following our relative optimism through last year (expanding centre of gravity: Aug’20, demand recovery in sight: Jun’20, built to last: Mar’20) and earlier. In this note, HDFC Securities examine key trends and growth prospects (top-down scenarios and long-term trends) and assess upside risk to the operating profile (margin sensitivity across key parameters).

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Top Picks: Infosys, HCL Tech, Persistent Systems, Mphasis and Sonata Software
 
The bar is raised to positive unchartered territory with the classic bundling of:

(1)   constructive market environment (cloudification, enterprise growth acceleration)
(2)   in-built and rising competitive advantage
(3)   Superior execution (with an upside risk to operational performance).
 

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Value migration to Indian IT companies: 
 
The sector’s competitive advantage continues to improve (50% of incremental market share within global majors) and the pandemic has further unleashed sectoral tailwinds of a multi-year accelerated digitisation/cloudification. Tier-1 IT incremental revenue addition is set to double as compared to prior period addition, translating to a 12% CAGR in USD revenue over FY21-23E.
 
Favourable denominator effect: 
 
Enterprise clients’ growth is accelerating and 12% CAGR for Tier-1 IT implies 7pp growth premium over enterprise growth vs. prior period growth premium of 5pp.
 
Broadening of vertical growth drivers and improving partner synergies: 
 
While BFSI vertical is expected to roll steady (rising tech spend-%), Manufacturing, E&U and Retail CPG are expected to accelerate (deal flow is up) and improve the distribution of growth (positive read-through for ER&D, HCL Tech). While synergies between hyperscalers/SaaS and Indian IT are improving, alignment via investments in sales/delivery is creating strong net new opportunities for the sector.
 
Improving operational rigour and margin sensitivity: 
 
The cost of delivery has arguably peaked in FY20 and we expect the sector margins at 10-year average (margin outperformance from Q3 levels expected in TCS, L&T Technology Services, Mphasis, Persistent Systems). The prospects of retaining the current elevated levels of offshoring are high and present an upside risk to margins (Mphasis/Mindtree). Our base case margin assumption factors 3/8% CAGR in onsite/offshore wage increase and we expect travel to revert to 60% of pre-pandemic levels. Better throughput is expected based on higher utilisation and offshoring, favourable supply-side scenario (both onsite and offshore), and demand fulfilment factors (training, lower sub-con).