IT sector seeing disruption, stocks underperforming: Should you go contra?

Analysts see growth remaining muted for the next two years, advise stock-specific approach

Another quarter has gone by and technology majors have again failed to live up to the expectations – a couple of them have even lowered guidance for seasonally weak December and March quarters. A mere 4% rise in the Nifty IT index year-to-date also reflects the challenges and disruptions the domestic information technology (IT) firms have been facing for the past few quarters. While valuations on the counter have come off at reasonable levels and the recent dividend/buybacks are seen supporting the stock prices, analysts believe a stock-specific approach across the sector makes better sense than contra bets at present. 

The Nifty IT index’s 4% increase so far this year looks pale before benchmark Nifty50’s 26% jump. Among individual stocks, Wipro has rallied 23%, TCS 10% and HCL Tech 1%, while Infosys has shed over 6% during the same period. 

In the September quarter, only HCL Tech retained a higher-than-industry-average guidance for FY18, of 10.5-12.5% growth in constant currency (CC) terms. Infosys trimmed its FY18 CC revenue growth guidance to 5.5-6.5%, while Wipro reported a muted guidance of 0-2% QoQ revenue growth for the December quarter. TCS does not forecast future earnings. 

Rakesh Tarway, head of research at Reliance Securities, noted growth would remain muted for the next two years, and advised looking at individual stocks with strong cash flows.

“The IT sector is currently undergoing a phase of disruption in the business model owing to trends like cloud computing, artificial intelligence, digitisation and automation. We believe these trends could continue to impact business growth for the next 1-2 years,” he said.

“However, given that IT firms are characterised by strong cash flows, valuations appear reasonable and there is a possibility of cash return to shareholders in the form of share buybacks (as seen with companies like TCS, Infosys, Wipro and HCL Technologies), it makes sense to adopt a stock-specific approach in the sector,” he added.

Among the midcap IT stocks, the expert prefers companies focused on specific verticals, especially higher-growth verticals like engineering services, or horizontals like products and platforms. 

“We like Cyient and Sonata Software among midcap IT firms. Among largecaps, we prefer Infosys to TCS, given a lower valuation,” he said.

Meanwhile, analysts at Prabhudas Lilladher estimated Infosys is trading at 13 times its FY19E, which is at a 25% discount to TCS. They retained 'accumulate' rating on the stock, saying the appointment of a new CEO would be the next major trigger for the stock.

Apurva Prasad, research analyst at HDFC Securities, pointed out while Q2 numbers might not have been impressive for largecap IT companies, the operational efficiency led by cross-currency benefits and growth in digital revenues stood out across the board. Prasad also noted IT stocks could be good dividend/buyback plays.  

HDFC Securities has a buy on HCL Tech with a target price of Rs 1,000. HCL Tech’s growth is at a premium to peers (1.4x), and valuations are at a marginal discount, it said in a note.

Between midcap and largecaps, HDFC Securities’ Prasad sees better valuation in the midcap space. The brokerage has a ‘buy’ on MPhasis, with a target price of Rs 750. The stock is trading at 15 times its Sep-19E EPS at present.