Digital, Cloud wave driving IT sector growth

Major crises have historically been a boon for the Indian IT industry. During trying times, domestic IT companies have witnessed increased offshoring and outsourcing. The companies too have risen to the challenge – ascending the maturity curve and providing cost effective and efficient solutions to the changing needs of global clients particularly adopting the latest Cloud and Digital technologies, according to an analysis report by Edelweiss Wealth Research.

The fortitude of Indian IT firms can be gauged from their ability to successfully ride multiple technology waves with manifold growth – from $8bn in FY00 to $191bn in FY20. Despite being labelled a labour-arbitrage industry, Indian IT companies have delivered higher margins (v/s the best global tech companies) along with healthy free cash flows, and gained market share in the largely fragmented global IT services sector.

The Covid-19 outbreak has forced businesses globally to recalibrate their business models to the changing customer landscape. The pandemic has unleashed exponential use of technologies, and thus, has been advantageous for tech players, especially Cloud providers. With technology emerging as the fundamental bedrock for growth, global Digital IT services spending is estimated to reach $900bn (at 16.5 per cent CAGR) by FY25E from $490bn currently.

Cloud and Digital are in a stage where technology has largely matured with standardized solutions (it can be customized based on business requirements). Further, Indian IT companies have significantly increased their presence in the new Digital world by acquiring capabilities through small company acquisitions, reskilling employees, and signing large transformational deals with Fortune 500 companies. Digital now contributes 30 per cent+ to the IT sector's revenue and is growing at ~30 per cent annually.

Over the last few years, margin performance of Indian IT was hampered due to the initial investments required to penetrate Digital/Cloud space. However, Digital business has now reached a healthy size. Also, the Covid-19 pandemic has engineered a structural shift – it will not only save costs for clients but will also be margin accretive for service providers.

The sector has witnessed strong margin expansion recently, which the analysts believe is sustainable on account of lower subcontracting cost, attrition, and SG&A spending.

The IT index meaningfully outperformed the broader market index since the Covid-19 lows made in March 2020. While the sector's valuation seems rich, it should not be viewed in isolation. Various aspects such as the macro environment, technology cycle, and earnings expectations should be factored in.

According to the analysts, FY22-23E will be another watershed moment for the Indian IT sector with companies witnessing healthy growth and margin expansion.

Top large-cap picks: Infosys (INFO) followed by HCL Tech (HCLT). Top mid-cap picks: L&T Infotech (LTI) and Mindtree (MTL).

(Edelweiss Wealth Research)