Street isn’t anticipating pricing compression for IT companies: Girish Pai

Do investors need to panic, or was this reaction anticipated from Infosys and the IT pack? In terms of revenue growth at constant currency (CC), Infosys has managed to surpass TCS for the fourth consecutive year. However, the latter’s margin has been ahead of Infosys for the last two years. What do you make of this scenario?

If you were to compare TCS with Infosys, TCS' numbers for the 4Q (fourth quarter) have been definitely better. We saw quarter-on-quarter (QoQ) growth of about 0.6 percent, whereas we saw (about) 3.2 percent compression for Infosys. And as you mentioned, the commentary has also been different. TCS mentioned only deferrers. They didn't talk about cancellations. Infosys did talk about cancellations. TCS mentioned that the month of March was probably a little worse off because of the banking situation in the US and Europe, whereas we saw a diametrically opposite, but much milder commentary, from Infosys saying that March was a month of stabilisation. So, contrarian views (were) expressed by both the players when they announced results.

Obviously, TCS doesn't give guidance for the year, though it says it aspires for double-digit growth, which to me looks fairly ambitious as we speak right now. And was I expecting this kind of reaction? Yes. I mean, we have been negative on the sector for a fair bit of time. We put out an underweight stance in April 2022. And the stance of 3-5 percent growth for tier 1 stocks is something we've had for a fair bit of time since July 2022. So, the kind of numbers that Infosys talked about have not come as a great surprise to us. We've been wondering when the macro impact will come through for the fundaments of the IT service industry. So, while the commentary of the management post Q3 had been fairly positive, we've been pretty sceptical of that, and it has played out as we speak now.

Will mid-cap IT now take a sharper knock, because of vendor consolidation and valuations still at a little premium compared to the large-caps? Do you think mid-cap IT names are more vulnerable at this point in time?

I would say so, and that's the call that we've had ever since we had this underweight stance. So, as you mentioned, the multiples are more expensive than of pure tier 1 stocks, and they were vulnerable because I think client concentration and vertical concentration are much higher for tier 2 stocks. And if there is some kind of pullback in spending by any of their top 10 or top 15-20 customers, that would have an impact on the growth rates. And while they corrected quite a bit, they ran up again into Q4 results. So, some of them are fairly close to their 52-week highs. So, I would think that tier 2 would likely be under more pressure in the quarters ahead.

Tell us of that one factor that managed to surprise you. Was it the net addition number, attrition, no clarity on wage hikes, or the commentary itself?

I think the biggest thing has to be revenue growth. Revenue growth hasn't been built in and a negative operating leverage plays on the EBIT margins, so that has kind of played out. The other things have been fairly well known. These have been happening for many quarters now. Attrition has been going down. The fact that they've not been hiring in a very material way, it has been something that has been fairly visible in the last few quarters. I don't think those were surprises to the street. Revenue growth was not coming through the way people anticipated. People were anticipating a weak quarter, but the number that Infosys delivered was definitely a bit of a shocker, and the fact that the management didn't see it coming does indicate this whole issue of visibility. So, I'm not sure whether there is a great deal of visibility going into the next few quarters.

And the other thing that I keep hearing from the management is that maybe March quarter is not so great and June quarter will also not be so great. But then things should start improving towards the second half of FY24. I'm not very sure whether that is going to happen. Because the macro event that everybody is waiting or watching for would happen, which is this recession or material slowdown in the US is not behind us, it is ahead of us, which means that if customers can behave the way they have done in the March quarter, when the US economy has been fairly resilient, how they behave once US goes into even a shallow recession is something one needs to wait and watch. So, I think there's going to be pricing compression, which the street is not anticipating right now, nor are the companies talking about. So, those are some of the things that are waiting.

Let's talk about the banking sector. HDFC has managed to deliver, as usual, a very steady set of numbers. Probably the bottomline is a bit of a miss on account of the OPEX performance. But how do you look at the banking scenario playing out because there's a slew of companies from the banking sector that will be reporting numbers this week? Do you see some pain coming in for the banking names as well?

Quite a few of them have announced their credit growth and deposit growth numbers and stuff like that. Looks like this year is going to close out fairly well, at least from a loan growth perspective. The only thing is that we've seen a little bit of margin compression on QoQ basis for HDFC Bank, which I'm not sure the street was anticipating. I think, it came in at about 14 basis points (bps) on QoQ basis. The cost of deposits has gone up quite a bit and also the fairly high level of OPEX ― the company has been talking about doubling its branch network, and obviously, that would entail higher OPEX. I'm not sure whether that level of OPEX growth was something anticipated by the market immediately.

So, going into why we are positive on the banking space, because we think a lot of the asset quality problems which plagued this sector, for say, the last decade or so, have been sorted out.

The issue is more in terms of credit growth next year ― FY24 credit growth. A system of why credit growth should be in the low teens. We're building in mid-teens kind of growth for HDFC Bank, ICICI Bank and some of the (other) private sector banks. If that disappoints, then I think… and with the kind of OPEX growth that HDFC Bank is talking about, we could potentially see some kind of downward revision to the operating profit growth, for say, HDFC Bank, for instance, for FY24.

So, the key thing to watch out for in FY24 would be credit growth. If credit growth disappoints, then that is going to be a bit of a challenge. But otherwise, I think things are fine. We have a neutral stance on the sector because we do worry about this credit growth aspect. But otherwise, valuations are relatively okay. I don't see a very big asset quality problem developing there. Broadly, most of those problems are behind us. There could be a few niggling issues that would probably come up next year when things slow down a bit. But otherwise, I don't see any great issues, or negative things. But, credit Growth is something to watch out for.

How about new-age companies? Motilal Oswal has come up with an initiation report on Zomato. It says that the food tech industry is still in early days, there’s a strong runway for growth ahead and Zomato to grow, but duopoly to delay scale gains. Overall, what's your view on new-age companies?

We don't cover them on an official basis. But, a lot of them are running at losses as we speak. Some of them have indicated that they will, at least on an adjusted basis, deliver EBITDA-level profits in certain parts of their businesses, not the entire business. Zomato has a food delivery business. They've also got a grocery delivery business. The food delivery business, from whatever numbers I've seen, seems to be slowing down a bit, because of consumption-related issues. Post-Diwali, consumption has been slowing down across India. That is showing up in the numbers of Zomato.

Whereas the fast-growing part of the business, which is the grocery delivery business, has an EBITDA margin problem or a profit-generation problem. That is a challenge in most of these kinds of companies. We need to study this a lot more closely. And my worry about some of these companies is the disruption that could potentially come through from some of the new entrants into the market because the absolute market cap of some of these companies is still fairly large.  And it's a very nascent business, and should a very deep-pocketed conglomerate or a new investor want to enter this kind of space, I would probably think that it could be disruptive.

In terms of valuations in the pecking order, if you could put Infosys, TCS, Tech Mahindra and HCL Technologies, along with the other peers, how would that order be? And how do valuations look to you now?

TCS is probably the most expensive. But that is the company which is probably going to give you the maximum amount of comfort if you take a two-three-year view on the sector. So, if you keep valuation aside, I would say my pecking order would be TCS, Infosys and HCL Tech in that order. But having said that, if you want to look at returns with a little bit of risk, I would probably think of betting on Tech Mahindra at lower levels, even lower than where it is right now; that could be an interesting thought because, unlike other companies, there are quite a few things which can be set right. So, there is a valuation discount, fairly significant valuation discount vis-à-vis TCS and Infosys. There is a revenue growth challenge that they've always had. Their margins have been very low or (at least) in the last few quarters.

So, there are quite a few things there that can be set right. And if all of those three things can be set right by the new CEO, who is going to join the company a little later and the impact of that is going to be felt sometime later down the road. Maybe that is a stock, which could potentially give you the highest returns provided you buy it at the right price. The current price is probably not the right one; maybe another 15-20 per cent lower than where we are right now could be a good price to get in. That could be the one that could give you, in my opinion, from a three-year perspective, the best returns. Maybe it's not the best company, but from a stock perspective, that could be the best… it could deliver you the best returns from a stock perspective. I'm assuming that Mohit Joshi will deliver.