Published on 10/01/2019 10:54:19 AM | Source: Emkay Global Financial Services Ltd

IT Sector - Reasonable valuations compel Overweight stance - Emkay

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Reasonable valuations compel Overweight stance

In CY18, the CNX IT Index outperformed the broader market by 21%. We believe that in last 12 months, the sector completed a full cycle: from depressed valuations (-1SD of 16x over its 5-year mean in Dec’17) to some irrational exuberance (+2SD by Sep’18), and then to a rerating of stretched valuations, with rationality prevailing in the end (+0.5SD).


* The four pillars of IT Index rally: In our view, broadly four factors led to the CY18 rally: 1) Gartner’s prediction for a significant growth uptick in IT spending; 2) INR depreciation; 3) sector under-ownership by domestic institutional investors; and 4) attractive payout yields. Among these, two have now neutralized with Gartner cutting IT spends growth estimates by 150bps to 5.9% in Nov’18 (we negated Gartner’s optimism in our July’18 report) and the rupee depreciation moderating amid falling crude prices. On the other two, funds are still underweight despite attractive valuations on a PEG basis; and although effective yields are down, large-caps’ yields still remain attractive at 2-4%.


* We got it right in CY18: In an eventful and tumultuous year for the IT sector, we can say without apprehension that – We got right both on BUY and SELL. First, we were ahead-of-the-curve in highlighting the Buy ideas in Oct’17 underpinned by our differentiated top-down framework-led research methodology on CEO analysis (using the ABCDEF framework). The names we identified (TCS, LTI and Mphasis) using the framework outdelivered peers both on the stock price appreciation and financial performance fronts. Second, when the stock performance turned largely secular due to euphoric sentiments, we remained selective in our approach. The sharp up-moves led to lofty valuations, resulting in our recommendations turning into Reduce/Sell across most of the names. Although many stocks on which we had negative stance saw very sharp upside movements for a brief period, they all achieved our downside target price after the market returned to rationality.


* Sector strategy for CY19: With the winning streak in CY18 now a thing of the past and the gains of the IT index receding significantly, for CY19 we are introducing three more analytical tools to our CY19 toolbox: 1) Client-based Global IT demand analysis: We have done an exhaustive sector-based analysis of the large client pools located across the US and UK that collectively account for about 70% of the revenues for Indian IT vendors, wherein the results reveal significant earnings gains accretion for these companies in CY17 and CY18E, giving us confidence on 3%+ growth for global IT spends and thus it would not pose any threat to our near-term growth estimates for Indian vendors. 2) Pricing analysis: Digital will not be margin-accretive as Technology is deflationary by nature. Digital services, like other segments in the past, would get commoditized with scale, and will turn deflationary. 3) Investor survey confluence (non-earnings factors): Our cumulative learnings from our interactions with more than 100 investors are also incorporated into our strategy. CY18 case studies have led to three core inferences: 1) investor preference for valuation-gap plays rather than structural buys; 2) preference for small assured growth and dividend vs. high-but-inorganic growth; and 3) premium for ‘known unknown’.

* Alpha-generating allocation strategy – CY19: We are Overweight on the Technology sector given growth certainty and favorable valuations on a PEG basis. Our CY19 recommendations for money managers: The biggest skew is coming from going underweight on Infosys (Underweight) and Tech Mahindra (Underweight) and allocating similar funds into high-growth names such as HCLT (a deep value buy -

* Overweight for us) and TCS (a structural Buy - slight overweight). In addition, by avoiding or going underweight on Wipro, we recommend higher weights to high-growth, sustainably-performing mid-caps such as LTI and Mphasis (both Overweight), as well as high-potential software plays such as OFSS (Overweight) (refer to Exhibit 54 for detailed model portfolio).


*Financial Snapshot (Consolidated)


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