Indian IT Sector Facing Severe AI Challenge: Is The 50% Valuation Gap Justified? | Midcap IT vs PSUs

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[00:00:00]catch that entire conversation on the interview with Aisha Faridi only on ET now. So, looking forward to catch that in fact myself as well. But let me bring on board Amish Shah. He's head India research at BoFa Securities joining us and we have the pleasure of having him in studio today. So, great having you here Amish.

[00:00:19]Amish to start off the earning season for Q4 has been more than fair frankly.

[00:00:24]We've done fairly okay for ourselves.

[00:00:27]But the risks seem to be looming with regard to FY27 really. That's where the real risk currently lies. Where are we in terms of valuations given these risks currently? We've seen a correction from the 52-week highs, but where are we in in your opinion?

[00:00:40]>> Sure.

[00:00:41]So, Harsh look valuation-wise India unfortunately does not offer comfort.

[00:00:47]You know Looked at multiple ways, you know, so when we look at India's valuation compared to its own history we are slightly higher than the long-term average. When you compare it to the emerging markets adjusted for growth, India at the peak used to be at 110% valuation premium to EMs. Currently it's at 73. Long-term average is 46. You know, so there's still some scope for valuation contraction rather than expansion. Compared to even bonds in India, valuations for bonds are now more attractive than the Indian equities.

[00:01:15]Right? So, valuation unfortunately is not going to be the driver for the market. Coming to growth, you know, because of the West Asia conflict primarily. Otherwise it was looking like a year that on a low base of FY26 growth, FY27 can be 14-15% earnings growth. But because of the West Asia conflict, crude, commodities, macro factors getting impacted, we down we now think that Nifty earnings growth for FY27 will only be 8 and 1/2%.

[00:01:42]>> Yes.

[00:01:43]That's pretty disappointing for many investors.

[00:01:46]>> I just a quick follow-up. Versus what what was it earlier for you?

[00:01:49]>> 14% is what we had started the year, but immediately as the conflict broke out we brought it down to 8 and 1/2 because we had to budget for higher crude, higher commodities, fiscal deficit higher, inflation higher, rates higher, currency depreciating, so on and so forth. You know, so when you pack up pack it all together, earnings growth has come and knocked down.

[00:02:10]>> So, you know, you have valuations which are above EM and still continues to be.

[00:02:15]You have earnings which have now been downgraded to 8 8 and 1/2% as you said before from 14%.

[00:02:22]And there's enough DI flows which is preventing the valuations to come down.

[00:02:26]So, are we going to see a time correction here or for the market?

[00:02:29]>> So, the way I would look at it is that valuation is not going to be the market driver. Markets will compound equal to earnings growth. If earnings growth is going to be 8 and 1/2, broadly that's the return that you will get from the markets.

[00:02:42]Domestic flows is a large part of even that 8 and 1/2% earnings growth. For whatever reason, if the domestic flows were to stem, then the valuation gap that we were talking about contracts.

[00:02:54]But we don't think as a base case that domestic flows does come off. As a result, we do think that valuation stays. Markets compounds in line with earnings.

[00:03:03]>> And so, where is the growth going to come from? Which sectors are you looking at for a composite growth of nearly 8 8 and 1/2%?

[00:03:10]>> So, you know, different indices different answers. But let's say if you stick to Nifty, banks I think is a large part of it.

[00:03:17]Telecom on the back of tariff hikes that are expected this year is a large part of it. Commodity plays is a large part of it because aluminum, copper, all of these prices are going up. And then you have certain subsectors like let's say industrials on the back of strong order book. We do think that you know, vast majority of them will do 15 to 20% earnings growth. And then shade higher is going to be utilities.

[00:03:41]So, they will do about 10 11. And then you have other sectors which are going to be a drag on growth like IT, staples, downstream energy and so on and so forth. You know, which is going to be a drag on the earnings growth.

[00:03:53]>> So, 50% of the Nifty is going to drive the 8 and 1/2% earnings, basically.

[00:03:58]>> You could say that, yeah.

[00:04:00]>> And you've cut earnings sharply, right?

[00:04:01]From 14% to 8 and 1/2% is is no mean cut.

[00:04:05]>> Absolutely.

[00:04:06]>> Where exactly is the pain most pronounced in your opinion?

[00:04:10]>> So, again, financials we had to take it down quite significantly because we are arguing for a 50 basis points of rate hike in FY27.

[00:04:18]>> Mhm.

[00:04:19]>> One hike in this year and the other other hike in January to March next year.

[00:04:23]Obviously, that impacts earnings for the financial sector. So, that is one.

[00:04:27]Commodity prices going up is actually a negative for the commodity consumers, like let's say autos, commercial vehicles, particularly, so on and so forth, you know, so that's and then downstream energy is where the large part of the earnings did get impacted.

[00:04:42]>> Mhm. Okay, so so auto, energy, and financials financials. And within financials, ideally, banks should benefit, right?

[00:04:50]Given the rate hikes.

[00:04:51]>> Absolutely. So, banks should benefit.

[00:04:53]However, there is a mark-to-market loss that they have to take from an earnings perspective on their on their portfolios.

[00:04:59]Yeah. So, on the treasury portfolio. So, on a net basis, on an operation basis, you're right that banks benefit, but earnings as a whole, you know, it gets nullified to a large extent because of the treasury portfolio.

[00:05:11]>> I understand. And how do you view private sector banks versus PSUs? What's the view there? It's It's the eternal debate, right? Which is playing out in March gets over the last 1 year. So, >> Private banks have been the cheapest in like like let's say last 30 years now.

[00:05:26]Definitely like that space. At the same time, we also like PSU banks. Not all of them, but but plenty of them. And then we are excited about the capital marketplace within the financial space.

[00:05:37]The pockets that we are staying away from right now is NBFCs impacted by rate hikes. And the smaller mid-size banks because they will have an exposure to commercial vehicles, MFI, MSMEs, all of that is going to be a little bit of a stress as of now.

[00:05:53]And insurance, which is a thematic long term, but there's no excitement to buy them immediately.

[00:05:59]>> Amisha, how do you look at some of the capital goods and power sector? Because in the last two to three weeks, we've seen a big run-up coming up in power.

[00:06:08]Alternate to energy, you have coal companies running up. You have power companies now, you know, running up now. How do you look at that sector now? Is it's alternate energy and thermal and others now going to be the theme as well?

[00:06:24]>> So, Sajid, a large part of their growth depends on whether the government comes up with policies for energy security.

[00:06:31]Logically and economically, it makes sense to come up with these policies.

[00:06:35]Will the government come? It's anybody's guess. Maybe that is the reason why we are also zooming in a lot during our conference with a variety of speakers and policy makers to explain us on what are they thinking in terms of energy security. But, think about it that, you know, as we know that this is not an India conflict. This is somebody else's conflict, but we are getting impacted only because we import a lot of energy.

[00:06:57]How do you, you know, if this were to happen next time, how does India not get impacted? By saying that, okay, what can we have our own energy sources where we don't have to import from the from the rest of the world. How do you do that?

[00:07:10]Plenty of ways.

[00:07:11]One of the examples is electrify. So, can you have more EVs at the cost of, let's say, a gasoline-run car? Can you have more induction cooking? Can you have an electric furnace for industries rather than a gas-fired furnace? Can you have biofuels that are, you know, that are that are manufactured more from the agricultural products and therefore replace, you know, crude. And can you also have coal gasification, which is India's coal converted into gas and brings down your imported gas. You know, so there are solutions to it.

[00:07:44]And as I'm saying that you know, when you do the numbers, there is an economic viability to do these things. But will we do it is uh you know, is a billion-dollar question. And we will see as we go along. In if India works towards these policies, I think the growth outlook of all of these firms that you mentioned improves meaningfully.

[00:08:01]>> Interesting, you know, because during COVID we saw digitization taking uh uh big leg up. There was a pivot to digitization and digital payments ecosystem that started off from there.

[00:08:14]Now, this is the right time to do an electrification pivot which which is there. If that is a thing, uh you know, is is a core policies initiatives that you are looking at from the government?

[00:08:26]>> Absolutely, you know, so see I I think it makes sense to do it. But how much should we do?

[00:08:32]Uh there are some sectors maybe where maybe let's say viability may not be established. As an example, we know that two-wheelers EVs, life cycle cost makes sense compared to let's say a gasoline-based scooter. But in cars, it does not make sense. So, can the government bridge that gap? The other other way to think about it is that EVs and EV charging stations is a chicken and egg problem.

[00:08:54]Right? Because till the time you don't have a higher penetration of EV cars, the charging station infrastructure does not become viable. So, can you can the government policies make it viable initially and then have a flywheel effect to it. So, you know, these are examples I'm giving you, but you know, in a variety like same goes for coal gasification and so on and so forth.

[00:09:12]Most sectors will require scale in order to become viable. But in order to kickstart the ecosystem, initially it will it will have to be driven by government policies and maybe some incentives in order to go for it. Will we see those policies is something that we will figure out next week.

[00:09:28]>> In this whole entire debate of energy security, one segment which has the most hit is the OMCs.

[00:09:34]Do you see OMCs also doing a pivot to alternate energy. Just not just on crude.

[00:09:39]>> And in some way they are, you know, so they are already working with green hydrogen, you know, as an example.

[00:09:45]They're also trying to diversify.

[00:09:48]In fact, why why only the OMC's? If you would pick up any PSU company, they're all trying to talk more green. You know, so instead of doing more thermal power plants, they're also talking about renewables. They're also talking about coal gasification. They're talking about green hydrogen, biofuels. All of this is basically pivoting slightly away from the conventional businesses towards more green businesses.

[00:10:12]>> Mhm.

[00:10:12]>> Mhm.

[00:10:13]>> And I'll I'll totally switch the conversation. What's the take with regard to IT? Because a large part of the Indian economy relies on IT as a space, both from an economic engine perspective internally and consumption and the like. What's the sense there?

[00:10:29]What's playing out?

[00:10:30]>> So, Harsh, from a IT sector, you know, growth perspective, we do think that, you know, the large IT companies are already down to 2 to 3% growth constant currency terms without taking the benefit of rupee depreciation. That we think now sustains. From a value, you know, throwing in valuations and therefore thinking of that as a stock argument or debate perspective, we do think that, you know, now they've come off to levels where I would we are still underweight on that sector, by the way.

[00:10:58]>> Okay.

[00:10:59]>> But we have toned down our underperformance. But at the same time, we don't see reasons to get excited or there are no there are no triggers to be excited, especially because there's a there is still a large valuation gap because you know, the international IT firms are trading at 9 to 10 P multiples, whereas the Indian IT firms large caps are trading at 15 to 16. The the mid caps are trading upwards of 25. Right?

[00:11:22]You know, so so and there is not too much of difference in terms of their growth or free cash flow yields.

[00:11:28]And even the client said that they cater to is the same.

[00:11:31]You know, so so in a variety of other sectors you can make an argument that India offers higher growth and higher returns and therefore Indian peers should trade at a premium to their foreign peers. But in IT you can't make that argument because they're catering to the same cohort of clients and the same markets and as a result you know, 40-50% kind of a valuation gap is too large enough. So, so we are not as excited to jump or bottom fish in that space yet.

[00:11:58]>> I understand on the IT part of it you mentioned because you mentioned about it.

[00:12:03]Many of the Indian companies are sitting on higher margin as compared to the global peers.

[00:12:07]I mean 20 to 25% the top rung companies which we are talking about and compared to an Accenture or a Capgemini or you know, Cognizant.

[00:12:17]Do you think that that would bring in some premium for the Indian IT companies?

[00:12:21]>> Oh, absolutely. I mean what I meant is not to say that 15 will go down to nine.

[00:12:26]But you know, the gap is still wide enough and that can that gap contract or at least at least doesn't see an expansion further is absolutely what we are thinking.

[00:12:37]>> Because we've seen a 10 PE contraction for many of the top rung companies from 25 to 15, for the mid-tier from 35 to 25 and now it will hover in this kind of a PE range for >> Most likely in my view Sajid. You know, so because you know, the times when when they were at 25 PE multiples, you know, their earnings growth was also much better and the outlook for that growth was also quite encouraging. Both of those are now obviously what questioned.

[00:13:01]We have from high single digit to early double digit growth, we are now talking about low single digit growth and clearly as a result of that valuation multiples did require to contract which they have. They may not contract further, but there is no reason why they should expand either.

[00:13:16]>> And the the entire AI challenge that the IT sector is facing, do you believe that there is merit in the fact that most people saying that India has completely missed out on this entire AI wave and so have IT companies. Is that fair to say or at some point the benefits will start to accrue? It's just a matter of time.

[00:13:35]>> It's more the latter, Harsh. We do think that the benefits will accrue. The debate now within investors is only about the timing of it. That can it get worse before it gets better?

[00:13:44]That's a tough one to answer and which is why because you cannot answer what will happen to earnings growth, you will want to reflect that in cheaper valuation multiples.

[00:13:52]>> And you think the worst is over or is the worst yet to come?

[00:13:55]>> The worst is over but there is no visibility of an uptick yet. So till that time the visibility does not come in, you know, valuation expansions is difficult to argue.

[00:14:03]>> And how do you play it? How do you play this theme from an India standpoint?

[00:14:07]>> So you know, look, if you're a domestic mutual fund manager, I would argue that you would have to be underweight IT.

[00:14:13]>> Right.

[00:14:13]>> If you're a foreign investor, you may you know, if there is no compulsion for you to own IT, you may not want to have it in your portfolio right now. If you're a hedge fund, you might probably want to still continue with long AI short IT trade which I think will continue to work.

[00:14:26]>> So so still no visible signs of an AI trade coming from India. That's is that is that the right way to kind of >> I mean, the the ecosystem plays exist like you know, we have data centers, cables, transformers, gensets and so on and so forth. That I think continues. But yes, when you I I are we going to be an AI large language model innovator? That unfortunately is difficult.

[00:14:50]>> Anything in your conference that you're going to be speaking about with regard to this entire theme? I'm sure that is something >> You know, we can't have a conference without AI.

[00:14:58]>> So I'm trying to understand what is it that that what's the theme that you all you'll be looking for as part of the >> So it's more it's more one of the questions that you asked that you know, when can Indian IT sector start seeing benefits of AI even as implementing it at the at the enterprise wide level. So A that, B within that particular ecosystem, what is it that we are going to be doing or accelerating like how many more data centers so on and so forth you know so that's the second.

[00:15:26]Third we are also now trying to do tech tie-ups right you know uh there are some Indian companies that are tying up with Nvidia etc. you know so how do we expand that ecosystem over over a period of time. So those are I think and and then finally and the most importantly is the application layer to it.

[00:15:40]>> Mhm.

[00:15:40]>> Uh that yes we are not the innovators of AI but how can we use AI to have more use cases? Uh that I think India will do quite well. Uh so how soon what kind of applications that is something that we would have to understand.

[00:15:53]>> most of the Indian IT companies have been arguing that they're trying to transform themselves into a AI tech services play.

[00:16:00]>> Yeah.

[00:16:00]>> Which is there. Uh which also means that you know going forward when you look at transformation deals which used to be 7 to 10 years long now it will be much crunched to 3 to 5 years.

[00:16:10]>> Yes.

[00:16:11]>> Is that does it will will it also bring in the crunching of the revenue as well revenue pie as well? There or the revenues will be much lower on on those deals?

[00:16:20]>> No so as I you know as we've seen that you know new technologies leads to expansion of the pie rather. Uh you know because we have still not seen the full use cases of what all AI can do and it's an evolving thing so it'll the use cases will keep on increasing.

[00:16:34]>> Mhm.

[00:16:35]>> So as that happens you know organizations like ours or others global firms uh they will want to keep on deploying that for more and more use cases over time.

[00:16:43]>> Mhm.

[00:16:43]>> And that we think that you know it's we are not worried about the revenue growth. Uh we are worried about the pace of that growth.

[00:16:50]>> Mhm.

[00:16:52]Mhm. Okay. Uh Amish thank you so much.

[00:16:54]Thank you so much for coming in speaking to us. You've been very generous with your time as well as your presence.

[00:16:59]>> Thank you very much.

[00:17:00]>> Thank you. Thank you always a pleasure.

[00:17:01]Right and and viewers we're out of time on this edition of First Trades. Thanks so much for tuning in. Hope this was productive useful.

[00:17:09]Hope there are plenty of takeaways at least plenty for us to take home. But out of time uh from Sajid myself everyone who to this show together thanks so much for watching. More action on the other side. You want to stay tuned [music] here on ET now.

[00:17:33]>> Yeah.