scorecardresearchIT Sector: DART has 0 'buy' calls and 2 ‘sell’ calls among top 10 stocks;

IT Sector: DART has 0 'buy' calls and 2 ‘sell’ calls among top 10 stocks; says midcaps more vulnerable

Updated: 30 Mar 2023, 02:40 PM IST
TL;DR.

Analysing the top 10 companies in the IT space, the brokerage had zero ‘buy’ calls and only two ‘accumulate’ calls. Meanwhile, it had 5 ‘reduce’ calls and 2 ‘sell’ calls.

The brokerage has 'accumulate' calls on HCL Tech and Tech Mahindra with potential upsides of 16 percent and 12 percent, respectively..

The brokerage has 'accumulate' calls on HCL Tech and Tech Mahindra with potential upsides of 16 percent and 12 percent, respectively..

While retaining a cautious stance on the information technology (IT) sector on the back of major macro headwinds and its correction in the last 12-14 months, domestic brokerage house DART said it believes that large-cap IT stocks are better placed than midcap ones.

Analysing the top 10 companies in the IT space, the brokerage had zero ‘buy’ calls and only two ‘accumulate’ calls. Meanwhile, it had 5 ‘reduce’ calls and 2 ‘sell’ calls.

The brokerage has 'accumulate' calls on HCL Tech and Tech Mahindra with potential upsides of 16 percent and 12 percent, respectively. Meanwhile, it has 'sell' calls on LTIMindtree and Persistent Systems with potential downsides of 13 percent and 14 percent, respectively.

Five stocks that have 'reduce' calls include TCS (5 percent upside), Infosys (6 percent upside), Wipro (5 percent upside), Mphasis (7 percent upside) and Coforge (1 percent upside).

The 10th IT company in the top firms' list is Cognizant.

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Top 9 IT companies (Source: DART)

"A declining global GDP growth, worsening macro conditions, ongoing banking worries (US/Europe banks) and war-related uncertainties clearly indicate further risk of slowing down of tech spending by global enterprises. Moreover, leading indicators for IT companies like delayed onboarding of freshers, flat-to-negative net additions in Q3, and moderating large deal wins depict growth moderation across IT services companies," noted the brokerage.

Midcaps more vulnerable

The brokerage believes that the above factors will affect mid-cap IT services to a greater degree as mid-cap average revenue exposure to BFSI (banking, financial services and insurance) is at 44 percent versus large-cap exposure at 29 percent, and higher built-in optimism in forecasts (emanating from recency bias).

Historically, mid-cap IT stocks grew much slower in the pre-COVID period than what is expected over FY23-FY25E, despite strong growth over FY21-FY23 and the brokerage believes moderation in growth rates for mid-tier names would lead to de-rating of valuation multiples as growth rate differential with large cap narrows down further (premium valuation for mid-tier would wane down and likely to get capped at par to TCS).

BFSI

In FY23E, amongst Tier I, Wipro has the highest share in BFSI (35.2 percent), followed by TCS (32 percent), Infosys (30.3 percent), HCL Tech (20.6 percent) and TechM (16.5 percent). While for mid-caps, Mphasis has the highest BFSI exposure (63.5 percent) followed by Coforge (53.5 percent), LTIMindtree (36 percent), and Persistent Systems (33.3 percent).

"If we look at Tier I names TCS, Infosys, and HCL Tech exposure to BFSI segment has been reduced systemically over last decade (FY13-23E), and thus we believe will have lesser growth impact from ongoing banking crisis as compared to mid-tier names such as Mphasis, Coforge and Persistent where BFSI revenue exposure has increased significantly in the last few years, and LTI Mindtree remained largely intact. TechM exposure overall basis is the lowest and thus least vulnerable to this issue at this point. Wipro is the only exception among Tier I names wherein the BFSI exposure has increased more so over post its acquisition of Capco which added another 400 bps to its BFSI exposure," stated DART.

Going ahead, the brokerage believes that there is potential for consolidation possibilities in the BFSI industry (as happened with the UBS-CS transaction) and also a shift in the business towards larger players (as we saw deposit shifts towards top-5 banks in the US) which would mean there would be very few banks that will have healthy growing financials, and thus better tech spends.

However, in such an environment, the market would become hyper-competitive among global tech vendors thus putting more pressure on pricing as the focus would shift to growth over margins in the near term, it warned.

Tier I likely to gain market share

The brokerage also expects Tier I names to gain from vendor consolidation exercise at the client end. Long-held relationships, wide competencies, and lower cost of operations would act as a differentiator for these companies. It pointed out that a hyper-competitive market would mean that client retention and expansion would be tough and also margin dilutive. Here too, DART believes TCS has shown the highest resilience historically in terms of managing best-in-class margins despite slowing growth, which could be a much steeper risk in the case of Tier II names where margins may slip sharply as growth rates moderate.

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Source: DART

High valuations

“Our Mid-cap coverage companies currently trade at an 8 percent premium to TCS vs an 8-year mean of 14 percent discount to TCS, implying there are huge downside risks for mid-caps companies as growth differential compared to large peers led by narrowing growth difference between large cap and mid-caps,” forecasted the brokerage. Clients prefer large tier-1 companies over mid-cap companies as they provide end-to-end capabilities and vertical expertise when there is fear of recession (as seen during the GFC crisis), it further stated.

Financials and valuation

The brokerage informed that it has curtailed its target multiple across IT services companies due to an uncertain macro environment and ongoing banking worries in key geographies. The target multiple cut is steeper in mid-cap companies as compared to the top 5 companies as it expects their growth to narrow further and that would make their premium valuation unwarranted. The only exception is Tech Mahindra, where the brokerage has upgraded the multiple as it has relative immunity from current challenges given its lower BFSI exposure and powering up of leadership team with the onboarding of new CEO that can potentially drive up growth expectations given his rich/scaled experience.

Given the ongoing uncertainty led by looming challenges in the BFSI vertical and many companies facing significant leadership changes, the brokerage remains selective in approach and maintains its preference for HCL Tech, Tech Mahindra and TCS.

 

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Source: DART

Forecasts

DART's IT services revenue growth forecast for FY23-FY25e at 8.3 percent is 230 bps lower than the consensus estimate of 10.5 percent and thus it seeds the risk for a severe cut in street estimates.

"We are cutting our target multiples across companies by 5-15 percent, given: i) Higher exposure to the BFSI sector in US/Europe which may have a cascading effect and drag growth; ii) Mid-cap IT services growth rates narrowing vs TCS (180bps difference in last 10 years vs 250bps in FY23-25E) which would have narrow mid-caps premium P/E vs TCS (8 percent premium vs average 14 percent discount historically) as growth moderates," explained the brokerage.

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Source: DART
First Published: 30 Mar 2023, 02:40 PM IST