Dipen Sheth: Why IT may be a buy despite automation threat

Indian IT companies have been "caught napping" by the shift in the digital space and the automation revolution but their shares reflect value on an absolute basis, believes veteran analyst Dipen Sheth.In an interview with CNBC-TV18, Sheth, Head - Institutional Research at HDFC Securities, said that if Indian IT companies do not speed up capital allocation which has been pending for so many years, then investors may begin to punish them."But these are still 30 percent core return on invested capital (ROIC) businesses and if there is promise they can regain growth after a year or two then this could be a good time to look at them," he said.On the overall market, Sheth said that investors seeking alpha then should look at bottom-up stock selection.Below is the verbatim transcript of Dipen Sheth’s interview to Anuj Singhal, Latha Venkatesh & Sonia Shenoy on CNBC-TV18.Anuj: For our markets it has been a bottom up stock pickers market, Nifty hasn’t done much, do you think that is going to continue?A: It has always been that way, so if you are a passive investor you buy an Index fund or something in just and sit on it for many years, but if you are really seeking alpha then there has to be bottom up stock selection. That is true for almost every market that you can think of across time, across geographies. I don’t think there is much to be said against that. Latha: I wanted to ask you more about Tata Consultancy Services (TCS) and Infosys and in fact the entire range of IT stocks. We had a guest earlier who said that okay they may not fall further, but they are dead investments given the Trump’s speech, we were discussing Trump’s speech. What is your sense can they rise or is your capital just locked?A: Certainly, I must confess that there is every possible headwind that you can think for the business. So, intrinsically, where is technology going? It is moving more towards platforms and automation and all of that which seeks to eliminate and release what Infosys calls FTEs or full time equivalents from the business. IT is now doing to itself what it has done to other businesses which is speeding up things to a level where it ends up eliminating jobs. I think some of these smarter IT companies have figured this out and that is what the digital shift is all about. Although all IT is digital, but specifically in the context of IT when you say digital it is all about getting into these disruptive technologies that entire smack space and of course a whole lot of other things where IT companies are now impinging on real world businesses so you have an Uber, you have an Airbnb and so on. So, IT companies are now becoming other companies. If it wasn’t enough to morph into higher versions or digital versions of themselves. I do believe that a lot of the Indian companies have been caught napping while this has happened and they have built up huge legacy businesses which now feel threatened. That said there has been a healthy awakening up of sorts and it has led from the front whether it is Vishal Sikka at Infosys or the next generation at Wipro. I think the big crib on IT is not that is going through a disruptive change where we fear they may not be able to keep up, but the fact that they now need to do that capital allocation which has been pending for so many years. Many of these guys are sitting on anyway between 10 and 20 percent of market cap in terms of the cash they are carrying on their balance sheets, so either they do buyback, they return this money or they put it to use on the streets of San Francisco and Boston as it were. If you can’t do that, then I think investors are going to punish you. That said these businesses are still 30 percent core return on invested capital (ROIC) businesses. If they are not growing for one and two years and if there is promise they can grow later, maybe this is a good time to look at them.Sonia: I am very interested in your investing themes for the next year. The PSU capex cycle is what you are looking at very closely and over there you have recently initiated on Engineers India (EIL). This is stock that has doubled over the last one year already. That doesn’t mean it won’t rise further, but what really is the story here and any other stocks in the same space?A: Look at the big picture, if you zoom out a little bit you will see that the private sector capex cycle has virtually beaten out and there is absolutely no hope barring some spots like maybe textiles or arguably cement in a while where you will see a little bit of capex. I don’t think we are looking at a very large private sector capex cycle playing out anytime over the next one or two years at least. In the interim interestingly, enough it is the government which has taken up cudgels on behalf of running the capex story as it were. So, you have huge spaces even wide spaces today like the railways, like defence and like refining where we are anticipating a huge rise in capacity and a switch to be BSIV which is almost over and now to BSVI emission norms, so a lot of capex is going to happen in refining. Interestingly, the last time around refining capex was required the government actually turned to the private sector, so Reliance and Essar put up that capacities. This time around the PSU refiners are in much better shape courtesy the lower crude prices and the healing of balance sheets that has happened. Many of them are now mid doubled digit return on capital (ROC) companies and much under leveraged compared to what they used to be two or three years ago. So, the capability that they have to raise money on their balance sheets and do this capex is much higher than what you would have imagined two or three or five years ago. Engineers India by the way is a natural beneficiary as it get design service contracts for all this capex virtually on assured basis without even a public tendering process courtesy its status as a PSU. We went through the balance sheet of EIL and we noticed that actually the core capital employed in the business is negative or zero which means here is a company which is sitting on potentially an infinite return on capital employed (ROCE) as it were a core ROCE of closed to infinity and which can grow dramatically over the next four or five years. So, the multiples don’t really matter, I think the visibility on the PSU capex is very high right now and hence Engineers India is a proxy.Sonia: The other space that has done well is the banking space, some of these private sector banks so IndusInd Bank post numbers etc. Federal Bank is another one that you like, the slippages are at a seven quarter low, but what kind of outperformance or value do you see in these stocks from now say over the next 12 months?A: In banks I think the argument has always been about distinguishing between value and quality. For a long time and this has now been overdue. We have been looking at PSU as perhaps a source of value and quarter after quarter the corporate heavy banks, let us not just use the PSU term here the corporate heavy banks whether it is an ICICI Bank or Axis Bank have stumbled at the asset quality hurdle. The latest quarter from Axis Bank is yet another confirmation of this.I think somewhere, until the corporate credit cycle improves, we will continue to find these banks at cheap levels and they will only be trading buys. So, the PSUs trade at one time more or less the private banks like Axis Bank or ICICI Bank will trade at 1.5 to 2 times more or less depending on where you are in terms of the mood parameter. On the other hand you have some very capable names, so we saw RBL Bank numbers recently, we don’t have them under coverage but I am quite amazed to see the growth and the resilience on their book. We saw IndusInd Bank which you wouldn’t believe that you are in the middle of a private sector asset quality struggle if you look at IndusInd numbers. I think full marks to them and they have got a very fee income stream as well and no wonder they are trading at a kind of multiples they are. Federal Bank has stumbled for a bit and struggled, but this quarter saw a very good pullback in terms of growth numbers. Partly, I believe that is got to do with changes internally in terms of the people they have hired and so on. I do believe that Federal is back to a gallop now and if that gallop comes with a commensurate control in operating cost then Federal has a very good story hereon because valuations are still pretty affordable and then of course you have the more capable names among the smaller guys like a City Union or a DCB Bank. So that entire banking space is now splitting into two parts it has always been that way but the patience is running thin on healing of asset quality at some of the stressed banks.