'The rally in IT stocks is very much justified'

We asked Kunal Sangoi, Fund Manager, Aditya Birla SL Digital India Fund about the near- to mid-term outlook for Indian IT and how comfortable he is with valuations of IT stocks now.

Kunal:

The rally in IT stocks has been very sharp. However, when we look at the fundamental trends, we think this is very much justified. IT services spending is witnessing a demand revival supported by three key trends in the enterprise IT spending, viz., modernisation of core infrastructure, adoption of public and hybrid cloud model, and AI adoption. Indian IT services firms have pivoted successfully to these new technology spend areas, have their efficient supply chains and have proved their execution capability even during the tough lockdown period with work from home. Digital revenues account for over 40 per cent of sector revenues and should see 20-25 per cent revenue growth across leading firms. In the past, Y2K (2000), Global Financial Crisis (2008) were triggers for the IT sector, which saw a major rise in offshoring spends. Similarly, the current COVID-19 pandemic is acting as a key trigger for increased digital adoption across businesses in multiple verticals.

Secondly, the growth recovery from the recession scare for the tech sector has been crunched to two quarters, i.e. COVID vs. GFC, where we are already seeing companies benefiting from the broader digital spending trends (seen in Q2 results and outlook going ahead). Outsourcing industry growth is estimated at 6-7 per cent as per Gartner over CY20-22 vs 4-5 per cent earlier as there could be a bounce like 2009. Offshore growth might rebound to high single digits with a stronger bounce in CY21/ FY22. Our thesis has been that the sector will see expansion of valuation multiples as the growth reaccelerates and earnings upgrade cycle follows (as seen in Q1 and now in Q2 quarterly results).

Over the near term, there could be some consolidation driven by volatility led by US elections and strong sector outperformance recently. However, over the medium term, we think the growth outlook going into FY22/CY21 is strong. The IT sector trades at P/E of about 23-24 times one-year forward earnings, which appears expensive versus its own historical average but is still lower when compared to some other defensive sectors like consumer (P/E of 34 times) and pharma (P/E of 29 times). Secondly, Indian IT companies generate healthy cash flows, have high ROIC, and have consistently increased the pay-out ratios through dividends/buybacks, which make the IT sector attractive to invest in.