Author: Rohan Samant, CA; Jinal Sheth, Sr. Portfolio Manager; Mansi Desai
The IT Industry has been in the limelight for the last one year for all the wrong reasons. Investors have been concerned about two key issues:
- Structural headwinds facing the industry due to the advent of cloud and artificial intelligence.
- Trump’s protectionist policies and his rhetoric on immigration and visa policies.
With these issues, prices of Indian IT firms have had a material and significant decline. Since March 2015, the IT index has fallen by 15% in an environment of strong market performance ex-IT. This clearly indicates investors shunning the sector.
“When everyone believes something is risky, their unwillingness to buy usually reduces the price to the point where it’s not risky.”
- Howard Marks
The extreme pessimism around this sector has led to under-ownership of the sector. Out of the 39 mutual funds, only 5 are overweight IT sector. At Multi-Act, we believe that it is at times like these that the best contrarian opportunities are available for a patient and long-term investor. But one just can’t be contrarian for the sake of it; prices are down usually for a reason, and thus, an ‘active’ investor needs to dig deeper to objectively address these concerns.
Structural shift towards Digital and Cloud Computing
The large IT players that we cover are certainly facing headwinds of parts of their conventional IT services business. Market participants are worried about the shift towards automation, budgets shifting from managing backend IT infrastructure to frontend business development like customer experience and digital marketing. Even at the back end, there is a shift towards cloud computing and SaaS.
Post the Global Financial Crisis in 2008, IT budgets of clients have always been constrained. More recently, the need of clients to invest in digital technologies has forced them to cut down on some of their other IT costs. Thus change in wallet share in a constrained budget environment has led to a slowdown in spend on traditional IT services.
While we are cognizant of these issues, one needs to separate the segments that are facing some structural headwinds (package implementation, application maintenance) from the ones which are not (application development, IMS, products and digital).
The reasons for the slowdown in the Indian IT industry are:
- Partly due to cyclical issues (constrained budgets)
- Partly due to structural issues (changing spending pattern + reduced effort requirement/automation).
Cyclical issues: The constrained budgets are a factor of low economic growth globally and zero interest rates regime which has affected profitability of BFSI segment, reducing their ability to expand budgets. We believe these issues are cyclical and once the global economy recovers, the IT budgets would expand and thus lead to a recovery of growth. If the companies were facing structural headwinds, they would be losing market share. In the table below, you can see that although the global IT spend growth has reduced over the years, the market share of Indian IT firms continues to rise. This suggests that a part of the issue is cyclical. At the same time, ROE and ROCE of the leading IT players continue to be high in the range of 20%-30% despite the headwinds towards their conventional business model.
Structural Issues: ‘Digital is not a threat but an opportunity’
Even though Indian IT firms presently do not have a major share of revenues from cloud computing and digital, we believe they are well placed to gear up to seize the next phase of growth from these services. As IT spends will rise, it makes complete business and economic sense for IT firms to increase their focus on the digital side of business.
Close to 16% of TCS revenues are already coming from digital business (Q3-FY’17).
We believe the package implementation business will be structurally impacted due to the shift to SaaS. But this would be more than compensated by the migration business that these companies would get for migrating from mainframe systems to cloud platforms like Amazon AWS.
As there is shift happening from the time-and-effort model to fixed-price projects, automation adoption makes immense sense for IT businesses, since it helps companies to maintain or improve margins while engaging in competitive bidding for new projects.
Read further about the Concerns (along with the noise) on H1 visa holders