Will AI kill the Indian IT Sector or Deep Value Opportunity? ( TCS & Infosys crashed )

What is the Impact of Terminal Value on IT Businesses?

Understanding Terminal Value in IT Sector

• The concept of terminal value is complex and varies across different types of IT businesses, making it challenging to assess its impact.

• Traditional business models have faced disruptions, leading to a reevaluation of revenue-generating functions within companies.

• The discussion focuses on the current state of the IT sector, which has been one of the worst-performing indices over the past year.

Insights from Industry Experts

• Siddharth, a CIO at Persistence Capital, shares insights gained from tracking the IT sector for nearly a decade and analyzing various business models.

• The performance decline in major companies like Wipro and TCS highlights significant shifts in market dynamics.

Historical Context and Performance Analysis

• Long-term success in India's stock market has historically been linked to IT services; analysis shows that NASDAQ 100 was a top performer post-dot-com bubble until 2002.

• Indian IT services have benefitted significantly from global digitization trends over two decades, with their representation peaking at around 16% in Nifty 50.

Current Market Trends and Shifts

• Recent narratives suggest that small-cap stocks are risky while large-cap stocks are safer; however, this year's performance indicates otherwise as TCS and Wipro face substantial declines.

• Despite being perceived as stable investments during downturns, large-cap stocks like TCS have underperformed compared to small-cap indices over longer periods.

Earnings Growth Concerns

• Questions arise regarding whether now is an appropriate time to invest or if it's merely catching a falling knife due to declining earnings growth projections for major firms like TCS and Infosys.

• The market's perception of terminal value adjustments reflects concerns about future earnings growth rates amidst evolving industry conditions.

Concerns Over Terminal Value in IT Services

The Challenge of Terminal Value

• Concerns about terminal value have arisen multiple times over the past decade, with the last significant instance occurring 8 to 10 years ago. This raises questions about the sustainability of IT service jobs and their downstream effects on white-collar work.

Deflationary Impact on Revenue

• A notable deflationary impact on revenue is acknowledged, particularly highlighted by a prediction from Anthropic's founder that 90% of their code will be written by AI. This suggests a shift away from traditional application development maintained by Indian IT firms.

AI's Role in Code Development

• The prediction indicates that for simpler projects, a greater percentage of software may initially be written by AI, leading to faster coding processes. This could reduce the need for human oversight in code checking.

Implications for Workforce and Revenue

• As coding becomes faster and potentially less reliant on human input, there may be fewer personnel required for code verification. Consequently, billable hours could decline, impacting overall revenue growth for companies.

Historical Revenue Trends

• Over the last decade, large IT service companies would have seen revenues increase significantly if not for operational leverage constraints. Despite improvements in margins due to sales team effectiveness in the U.S., productivity gains must ultimately benefit end customers.

The Competitive Landscape of IT Services

B2B Business Dynamics

• The nature of B2B business emphasizes relationships and execution capabilities; however, even major players like Infosys and TCS face challenges maintaining these relationships amidst rising competition.

Risk of Client Migration

• If productivity benefits are not passed onto clients, there is a temptation for them to switch providers despite potential switching costs involved.

Audit Industry Changes Due to AI

• Recent trends show that auditing firms are reducing prices due to efficiency gains from AI technologies. This raises questions about whether similar price reductions will occur within IT services as well.

Market Valuation Concerns

Changing Perspectives on Growth Potential

• There is an acknowledgment that while listings may occur in ten years, market multiples have decreased significantly due to changing perceptions regarding growth potential within the industry.

Operating Margin vs. Revenue Growth

• While operating margins may improve due to increased engineer productivity, revenue growth has stagnated or collapsed entirely across many firms.

Investment Sentiment Towards IT Stocks

Current Market Multiples

• Current PE multiples for Nifty IT stocks hover around 23x forward earnings estimates which reflect cautious optimism given low expected revenue growth rates between 10% - 12%.

Investor Expectations

• Investors are wary when pitching stocks with low sales growth expectations against high market PE ratios; this leads to skepticism regarding future returns compared to broader index performance.

Challenges Facing Foreign Institutional Investors (FIIs)

Returns vs. Capital Gains Taxation

• FIIs face challenges investing in Indian IT services stocks as they seek nominal returns while contending with capital gains taxes which diminish net profitability from investments.

Currency Depreciation Effects

• While it’s often claimed that Indian IT companies perform well during currency depreciation scenarios, this holds true only if there isn’t a deflationary impact affecting their core business operations.

Overall insights suggest significant shifts driven by AI advancements and changing market dynamics pose both risks and opportunities within the Indian IT services landscape.

Finding Unique Market Leaders in a Bear Market

Overview of the Workshop

• The workshop focuses on identifying unique market leaders and businesses during bear markets, specifically discussing competitive advantages and independent discovery methods.

• Scheduled for February 22 at Hilton Hotel in Chennai, with limited seating available (20-25 spots).

SOIC Membership Benefits

• SOIC is a teaching organization that covers financial planning, fundamental analysis, intrinsic valuation of stocks, and portfolio allocation. Level four includes strategies for buying and selling stocks independently.

• Level five teaches stock screening techniques while level six explores different sectors' languages. An added bonus includes an AI investing masterclass for members.

Insights on Market Trends

• The workshop will also provide insights into current market views, sector performance, earnings trends, and how to navigate the bear market cycle experienced over the last seven to eight months. These insights are part of the SOIC membership benefits.

• A one-time coupon code "SOICBONUS10" offers a 10% discount on membership fees related to intrinsic value assessments. Registration links for the Chennai workshop are provided in the description box below the video.

Challenges in Traditional IT Service Business Models

Disruption in Business Models

• Discussion highlights that traditional IT service business models have faced significant disruption; it's challenging to assert they have completely broken down but signs indicate substantial changes are occurring.

• The industry previously enjoyed growth rates around 8%, but now faces potential deflationary impacts affecting revenue growth estimates across companies despite possible margin increases.

GCC as a Solution

• GCC (Global Capability Centers) are emerging as integral parts of companies like Google and United Health Group by outsourcing non-core functions while maintaining profitability through cost savings and specialized work tailored to company needs.

• Companies can train employees based on specific business contexts within their organizations rather than relying solely on outsourced services from other jurisdictions which historically posed challenges due to regulatory navigation and hiring difficulties.

Future Outlook

• Despite disruptions, it cannot be definitively stated that traditional IT business models have collapsed; however, there are clear signs of transformation reflected in PE multiples and stock prices indicating shifts towards new operational frameworks amidst ongoing economic pressures such as inflation or deflation trends impacting revenue growth projections across various sectors.

IT Business Opportunities and Challenges in India

Overview of IT Services Landscape

• The Indian IT services landscape can be broadly categorized into five segments, with large-cap IT providers being a significant player.

• Large-cap IT companies offer a wide range of services including R&D, product sales, BPO, KPO work, application development, and testing.

• Their value proposition lies in vendor consolidation; they can provide comprehensive solutions to clients looking to outsource multiple functions.

Growth Challenges for Large-Cap IT Providers

• Historically, large-cap companies have struggled to show growth despite winning Total Contract Value (TCV), which reflects new business won within a year.

• CFO scrutiny is high on these accounts as they assess the productivity benefits from AI investments amidst fluctuating revenue streams.

• The challenge remains for these firms to demonstrate growth while maintaining margins; shareholder expectations are critical for stock prices.

Market Dynamics and Historical Context

• Investors often look for opportunities when stocks are undervalued compared to historical averages; examples include HDFC and Kotak during market downturns.

• Comparisons between banks like SBI and HDFC reveal that turnaround stories can lead to higher valuations based on performance metrics.

Revenue Growth Trends Post-COVID

• The pandemic accelerated digitalization trends but has led to normalization in revenue growth rates across various sectors including Infosys and Wipro.

• Current P/E ratios reflect adjustments post-COVID as businesses recalibrate their growth expectations against historical performance.

Emerging Segments: ER&D Companies

• The second segment includes ER&D companies like Tata Alexi and KPIT that focus on low-cost R&D solutions globally.

• These firms assist major automotive players transitioning from traditional platforms to electric vehicle technologies by providing advanced engineering solutions.

Challenges Facing Mid-Cap and Small-Cap IT Services

• Mid-cap firms face challenges if their end customers are losing market share to competitors; this impacts their growth potential significantly.

• Demand vertical dynamics play a crucial role; if demand declines in key markets such as automotive, it poses risks for sustained growth.

Understanding Deflation in IT Services

Impact of Manufacturing and Cost Structures

• The discussion highlights the significant deflation observed in manufacturing as a percentage of revenues, particularly in Europe where growth is stagnant.

• There are concerns regarding customer disruptions affecting growth; even if customers are not disrupted, the extent of deflation they will experience remains uncertain.

Categorization of IT Services

• The speaker categorizes businesses into different segments, focusing on mid and small-cap IT services which show considerable variation in operations.

• Companies involved in reselling Microsoft products or those engaged in process engineering and cloud migration fall under this category, indicating diverse operational focuses.

Revenue Trends and AI Influence

• There's an argument that selling more AI-related products could provide revenue tailwinds for companies specializing in application development and maintenance.

• The impact of AI is discussed concerning its ability to pull information from various data silos, potentially increasing vulnerability to cyber attacks.

Cybersecurity Opportunities

• Specializing in cybersecurity can be beneficial as companies may increase spending on security measures due to rising threats.

• A notable example includes a listed IT service business whose market cap is significantly lower than its total contract value (TCV), raising questions about valuation metrics.

Execution Risks and Market Dynamics

• Concerns arise regarding execution risks associated with mid-cap IT businesses compared to larger firms that have stable operations.

• It’s essential to assess whether these companies genuinely engage in application maintenance or if they merely use buzzwords without substantial backing.

Understanding Margins and Revenue Sources

• Evaluating the margin profiles of these businesses is crucial; full margins might lead customers to demand higher prices amidst potential revenue deflation risks.

• The conversation emphasizes the nuanced challenges faced by mid-cap and small-cap firms while acknowledging ongoing revenue deflation risks.

Process Specialists: A Unique Category

• The final category discussed involves process specialists who operate on a labor cost arbitrage model, selling time for money based on their expertise versus customer needs.

• High-stakes outcomes such as insurance reimbursements are less prone to disruption due to the high costs associated with errors, contrasting with low-stakes outcomes.

This structured summary captures key insights from the transcript while providing timestamps for easy reference.

Bounded by Outcomes, Not Time or Labor

Understanding Company Focus and Specialization

• Companies like Sigility and IKS are evaluated based on their outcomes rather than time or labor invested. This perspective emphasizes the importance of assessing whether they provide critical services.

• Many companies focus on specific verticals, offering hyper-specialized services that customers prefer not to handle themselves, leading to significant productivity improvements.

The Role of Compliance in Specialized Services

• For example, Indigene prepares marketing collateral for farmer companies, which involves strict compliance with various requirements. This highlights the complexity and human contextual awareness needed in specialized fields.

• While some companies may be less impacted by AI advancements, others might see increased productivity benefits despite potential deflationary pressures.

Customer Dynamics and Market Challenges

• Companies selling to struggling customers (e.g., insurers facing cost pressures) may find opportunities for outsourcing services that could benefit them amidst market challenges.

• The discussion shifts towards international investing trends, particularly regarding SaaS companies and their performance in a challenging economic environment.

The Impact of SaaS Companies on Investment

Current Trends in Software as a Service

• SaaS stocks have seen significant declines recently; notable examples include Salesforce and Figma experiencing drops of 70-80%.

• Investors are encouraged to study these companies closely to understand the disruptions affecting their business models.

Revenue Growth Strategies in SaaS

• Historically, SaaS growth has been driven by increasing license sales within existing accounts. A company can grow revenue significantly without acquiring new clients if it expands its product offerings effectively.

Challenges Facing SaaS Pricing Models

Evolving Pricing Strategies

• There are two primary pricing strategies: seat-based pricing and usage-based pricing. Usage-based models reflect actual consumption rather than just seat count.

The Challenge of Growth Without Seat Expansion

• Organizations face difficulties growing seat counts when overall headcount is flat or declining. For instance, Microsoft’s headcount growth contrasts sharply with revenue changes in certain regions like India.

Navigating Complexity in Sales Processes

Shifts in Sales Dynamics

• Selling more seats becomes challenging when organizations do not expand their workforce. Sales teams must adapt strategies accordingly to maintain revenue streams.

Domain Expertise as a Competitive Advantage

• Many successful software solutions leverage domain expertise that cannot easily be replicated by cheaper alternatives. This expertise often solidifies customer loyalty over time.

Emerging Technologies and User Experience

Innovations Transforming User Engagement

• New technologies such as Adobe Firefly demonstrate how user experience is evolving rapidly. Users are encouraged to explore these innovations for enhanced functionality.

This structured approach provides an insightful overview while allowing easy navigation through key discussions from the transcript.

Understanding Market Dynamics in the IT Sector

The Value of Cash Flow and Earnings Multiples

• The respect given to certain sectors, particularly IT, is notable; these businesses often trade at significant earnings multiples, typically around 20-40.

• Free cash flow can be misleading due to factors like negative working capital and stock-based compensation diluting perceived value.

• Companies with high revenue growth (30%) are questioned on their premium treatment in the market despite potential dilution from stock options.

Comparisons with Other Sectors

• When comparing IT to semiconductors, it's noted that semiconductor companies maintain high operational rigor and still trade on earnings gaps despite recent rallies.

• The consolidation within the semiconductor sector leads to higher sales multiples, yet some companies like Oberoi Hotels receive less attention than they deserve.

Market Perception Shifts

• As sectors lose their "special" status, investors begin questioning premiums or discounts applied to stocks based on earnings multiples.

• Hiring trends indicate a challenge for companies facing disruption at a fundamental level; new user interfaces are changing distribution dynamics.

Challenges Facing Growth Companies

• Venture capitalists are now funding AI-native competitors that trade at lower multiples but require only modest growth rates for valuation increases.

• There’s skepticism about whether investing in rapidly growing companies is worthwhile given current market conditions and inflation impacts.

Opportunities and Risks in the IT Sector

• Different segments within large-cap IT face unique growth challenges; mid-cap and small-cap firms have distinct nuances worth exploring.

• Disruption is evident in SaaS companies where hiring isn't reflecting market needs; however, differences between GAAP and non-GAAP earnings are becoming more recognized by investors.

Conclusion: Navigating Investment Decisions

• Investors should consider how perceptions of value have shifted within the IT sector as many stocks have fallen significantly from previous highs.

• Understanding areas of opportunity requires careful segmentation analysis within the IT landscape to identify promising investments amidst broader market volatility.