Friday, February 24, 2023

Expect Digital Revenues For The IT Companies To Grow In The Range of 25-30%: Emkay Wealth Management

* Near-term headwinds offer investors an opportunity to accumulate

* Investors should invest in a gradual manner with a minimum horizon of 3 years

* Indian IT is a structurally resilient and a long-term growth-oriented sector

Emkay Wealth Management Global Financial Services has released a note on the Indian technology funds, the investment opportunity, scale, and the fundamentals of the tech companies. The research house expects the Indian IT companies to do well basis their experience over the past two decades in handling disruption, changing geographical presence, currency gains, attractive valuation, economic recovery in the west, and relatively unchanged tech spending. Emkay Wealth Management expects digital revenues for IT companies to grow in the range of 25% to 30%.

Expanding contribution to the economy and growth

The Indian tech sector has been gaining prominence in terms of its contribution to the overall economy, employment, innovation, and resilience. The relative share of the sector in Inda’s GDP is 7.40% and the share in service exports is 51%. The sector employs more than 5 million people, and the trend of employment is gradually accelerating, and the sheer size of the employment is going to be of astounding proportions.

India is already the third-largest start-up hub for tech start-ups with close to 2500 new startups and 45 unicorns. Digital revenues are likely to grow at 25-30%. All major segments of the industry are growing at a double-digit rate, IT services are growing at around 17%. Whether it is infrastructure management, cloud-based testing services, cloud migration, consulting, etc. all are growing at a decent pace.  The other growth areas are networking services, AI and analytics, platform-based services, etc. ability to respond to customer needs, focus on creating future-ready solutions, and accent on customer centricity are some of the interesting features of the business approach.

Fundamentally strong domestic companies

The domestic tech space is fundamentally stronger today than it was at any time in the past. This is due to a number of factors that have actually evolved over the last two decades. 

(i) Experience of the past to handle disruption: The tech companies have faced recessionary conditions and sluggish economic conditions at least thrice during the last two decades and have already weathered the storms and the business models are stable at present. The experience of the last decade has provided these companies with enough data to plan things ahead more effectively. 

(ii) Geographical diversification: The geographic diversification of business was more skewed towards the US and America, and this has undergone changes with the exposure to the US coming down by almost half of what it was before as business expanded to Europe, Africa, Australia, and the Middle East too.

(iii) Currency gains: The Rupee has been weaker and those who would plan their receivables with an appropriate budgeted rate for the receivables and a sound hedging policy would tend to gain in the future too. The forex gains cannot be ignored in the overall scheme of things.

(iv) Attractive valuations: The last few months have seen a significant amount of price correction in the tech stocks ranging from 25-30%. The price correction makes the relative valuations attractive as the mid-cap companies where the valuations were overstretched have moved down. The Nasdaq has been declining with each passing day in the last three months and this trend may continue for a little more time as the tech platform companies could face some more rough weather due to the evolving business models, competition, and the gap between delivery and customer expectations.

(v) Economic recovery in the West: The macroeconomic headwinds emanating from persistently high inflation and the resultant hike in policy rates and the rise in market yields could eventually result in a slowdown in economic activity. However, many estimate the slowdown in the US or Europe might be rather weak and transient and it may not affect economic activity too badly.

(vi) Technology spending is required even when the economy may not be too sound. Businesses need to run, and the experience of the pandemic is that technology gained more prominence mainly through online platforms covering a host of things like digital content, social media, gaming, and e-commerce. The global technology spending, excluding hardware, was close to US$ 1.70 trillion in 2021, close to 10% growth. The global sourcing market during the same period showed a growth of 12-14%, that is, US$ 240 billion in 2021. This shows the resilience of the industry.

The IT sector has been facing the perfect storm at the global as well as domestic levels over the past few months. The sharp run-up in inflation globally, and the resultant aggressive monetary policy actions by central banks in the developed economies (the major market for IT companies) to contain inflation resulted in recessionary expectations gradually gaining ground.

The expectations of a slowing economy transforming into lower digital spending were reflected in the price performance of domestic IT companies. The high attrition rates and cross-currency movements (while INR depreciated against USD, it appreciated against other global majors such as GBP and Euro) created margin pressures. The double whammy of risks to revenue, as well as margin, has led to valuations easing in the IT space.

The near-term headwinds offer investors an opportunity to accumulate assets from a structurally resilient and long-term growth-oriented sector. As has been discussed earlier, IT spending can moderate over the near term but the maintenance of existing IT infra and digital transformation of businesses across sectors and size of businesses will keep demand for Indian IT services strong. Given the near-term headwinds, investors would be advised to invest in a gradual manner with a minimum horizon of 3 years.

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