“Tier two IT companies probably will get much higher valuations because they are the growth stocks and are not just necessarily defensive. If the larger IT companies grow at 10, 12, 13%, a lot of tier two IT companies can grow at around 15-20%, more like 17-18%. When we have a situation where revenue growth is 17-18%, margins are north of 20%, ROE is 25% and some of the companies are hitting a billion dollar revenue mark, they will deserve even better valuations,” says Nilesh Shah, MD & CEO, Envision Capital
Wall Street the bears are saying we are the boss, in India the bulls are saying we are the boss, who is the boss?
I guess both are bosses. The US is staring at a recession. There’s high inflation, high interest rates, demand destruction, slowdown and recession, that is a reality for the United States. For India it is very different. We seem to be cruising along at the 6-7% GDP growth rate, with inflation rates even lower than what the US and the Euro Zone are experiencing.
I do not think in the last 30 years of my career we have even been at this situation where we are having higher growth and lower inflation versus the developed economies. That is truly a goldilocks moment for India and it looks a lot more sustainable than what we have seen in the past cycles.
I would tend to agree that the US has its own set of challenges and India is having its own set of opportunities.
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We are using the word decoupling once again. A polite reminder here is that 2007, when we used the word decoupling, it came back and haunted us. If the world is slowing down, can we be isolated?
Surely, we would not be isolated; there will be some bit of collateral damage. Decoupling is being too optimistic or stretching it too much. But we will have less coupling. What has changed between the past cycles and now is the whole China plus strategy. I am talking in the context of global demand, its impact on India and India’s exports.
The kind of policy changes that we have had in the last five years provide a strong tailwind to Indian exports; PLIs, GST, the whole availability of power, lower interest rates, all these essentially are strong tailwinds for India’s exports. And on top of that geopolitically things have changed quite dramatically.
Everybody is looking for that China plus destination, India clearly seems on top out there in terms of the choice for the China plus destination and that to me I think is a huge positive for India. So while the world will slow down, India will continue to get its fair share of exports purely because globally Fortune 500 companies are looking out for other destinations to outsource from and that I think is again a huge positive for India.
Let us start with a sector which you track very closely, IT. At the beginning of the year it was all about IT, nothing could go wrong now the consensus is nothing could go right. Is there a middle place where IT will settle?
It looks like. I clearly believe that the froth is out, margins are going to settle at slightly lower levels but demand should not be such a big challenge, demand should sustain.
Even in CY2021, our technology companies were growing at 15-20%. That was not the case, they were probably growing at about 10-15%. That kind of a number is sustainable because the demand for India’s IT services is very non-discretionary; it is all about application development and maintenance of technology platforms, digitisation and all of that. That is a reality and I do not see demand being affected.
What I definitely see are margins coming off quite significantly from the highs that we have seen in 2021 and that should be fine and valuations also have come off quite significantly. Stock prices have corrected quite significantly. I probably do not think that we are going to see a correction of more than 10-12% in IT stocks from here.
The index is down 25% this year?
Yes, so maybe we will have another 10% correction. At that point of time, IT becomes very attractive from a medium to long term perspective.
The IT sector is likely to grow let us say in early double digits and there is a dividend yield including a buyback will be done of about 3-3.5%. What is the real PE multiple the market should give to a business like IT services?
If we look at our markets on one hand, we have the consumer companies growing which get a 50 plus PE multiple. We have a lot of B2B companies which get 10 to 15 PE Multiples. IT should been somewhere in between and probably around 25 times on trailing earnings. That creates a good opportunity for the large cap IT companies.
Tier two IT companies probably will get much higher valuations because they are the growth stocks and are not just necessarily defensive. If the larger IT companies grow at 10, 12, 13%, a lot of tier two IT companies can grow at around 15-20%, more like 17-18%. When we have a situation where revenue growth is 17-18%, margins are north of 20%, ROE is 25% and some of the companies are hitting a billion dollar revenue mark, they will deserve even better valuations.
If at all, I think liquidity will gravitate away from largecap IT companies to some of the tier two IT companies and that is the big opportunity.
The sweet spot for midcap IT is engineering design services. These businesses have had a deep swell in the last two or three years but since there could be a recessionary trend in Europe and the US, obviously it will start impacting the capex and demand for engineering and design services. Thus while the need for largecap IT businesses servicing banks, pharma, retail verticals will continue, specialized companies will bear the brunt of recession?
Nilesh Shah: Partly true but I still believe that the two big things going for India are a)the competencies and b)essentially the cost. There is still a cost arbitrage between the salaries of people in the US versus salaries in India. There is still a huge difference when you face a slowdown. In a recessionary environment, it is very normal for businesses to see how cost can be rationalised and in that environment the case for offshoring gets even stronger versus an environment which was there in the last three-four years.
I actually believe that though there could be a bit of a pause for a quarter or two, post that, we would see offshoring gaining even bigger momentum. Keep in mind that the dollar is strengthening and the rupee is depreciating. That makes our cost proposition even more attractive than what it was in the past.
Obviously the starting point is competencies and our technology services companies have great competencies. They add value to their clients. On top of that, there is a cost arbitrage which is even getting more compelling and is going to swing hugely in favour of some of the tier two companies which offer very specialised offerings.
You are still holding on to LTTS?
Oh absolutely. It is amongst our top holdings and we like it. We like what they do. This financial year, they are going to be hitting a run rate of a billion dollars in revenues and the other big opportunity is the fact that their EBITDA margins are around 20% which is way lower than the EBITDA margins of some of the larger IT companies. The larger IT companies have EBITDA margins of more like 24-25%
But that is
. would be 23-24 PE Multiples, is sub 20…
Yes, but I would probably put Wipro and separately. But if I were to just look at Infosys and TCS, their EBITDA margins would range at 23 to 25%. If you look at some of the specialised companies like , their margins are north of 30%. Nor for me this whole journey from 20%, leave aside the 30%. The journey from 20% to 23% may be even over a period of three to five years and a solid revenue growth which is in mid to high teens.
It is a great combination to have with the kind of pedigree and the capabilities that L&T Technology and Services have. We have been owning it now for a long period of time and continue to own it and continue to be extremely positive about it.
What will challenge your belief in LTTS, what would be the data point which will tell you okay I am not okay now with what they are doing?
I would still think there is a business opportunity there. The ability to gravitate towards higher margins is going to be the big opportunity but if that does not happen, then I would doubt the way they are probably running the business or the way they basically see the opportunity because I think the kind of work that they do, they sure can drive better margins. Right now scale is a challenge, they are still not yet a billion dollar revenue company; but once you get into $1-2 billion revenue game, it should manifest in better margins.
I would want to see LTTS move from that 20% EBITDA margin to 25% margin. I am fine if it takes another three to five years but to me that is the big thing. The day it happens, there will be a very strong case for a further rerating of LTTS but if that were to not happen I think that would concern me.