In the last five years, among the top IT services companies in India, HCLTech stands out rank apart with 228 per cent returns as compared to TCS’ 107 per cent and Infosys’ 167 per cent returns. What underlaid this outperformance? Earnings growth, margin expansion or something else?

Earnings of HCLTech have grown at around 9 per cent CAGR in the five years from FY19-24, similar to that of TCS, while both have underperformed the 11 per cent CAGR delivered by Infosys. When it comes to margins, it has declined for all the three companies in the last five years. While trailing twelve-month EBIT margins for HCLTech and TCS have declined around 100 basis points (bps) as compared to FY19, it has declined nearly 200 bps for Infosys. But important to note here that as compared with TCS and Infosys’ margins at 24.5 per cent and 20.7 per cent, HCLTech’s margins are actually lower at 18.2 per cent.

When you consider growth from here too, it is not much differentiated with consensus estimates implying 9-10 per cent revenue/earnings growth for the companies. So, as such there has not been any significantly differentiated performance from HCLTech.

Significant re-rating

If you get into more details, it is clear the outperformance of its stock has been driven by a significant re-rating in its valuation. Ten years ago, HCLTech traded at 33 per cent and 20 per cent discount to TCS and Infosys respectively. Five years ago, it traded at a 37 per cent and 23 per cent discount. So, largely the valuation discounted has persisted for long periods.

However, the recent years have seen this discount getting eliminated. Today, HCLTech trades on par with Infosys and at a very marginal discount to TCS.

At bl.portfolio, we had pointed out the opportunity the discounted valuation provided and had recommended investors to accumulate the stock of HCLTech in September 2022 when it was trading at around ₹900. Subsequently, as much of the rerating played out, we recommended investors to book profits in the stock in January 2024 post nearly 70 per cent returns when it was trading at around ₹1,550. By then, its valuation had come almost on par with Infosys, although Infosys’ had better margins.

Nevertheless, the re-rating has not only sustained so far, but has got even better, with HCLTech now trading only at an eight per cent discount to industry leader TCS. This is where things are going to get even more challenging for HCLTech. With growth not differentiated, and margins significantly lower as compared to TCS, the chances are high that the valuation will see some derating from here.

Lower moat

Thus, even if one were to take a positive view on the IT sector stocks (at bl.portfolio, we remain cautious given unfavourable risk-reward at current valuations), one needs to remain cautious on HCLTech.

At present HCL Tech has similar growth and lower margins versus TCS and Infosys, but at the same time trades on par. In terms of scale too, (larger revenue slice can compensate for lower margins) it is smaller versus the other two companies. In this circumstance, it will be hard for it to trade for too long at on par valuation. The logic is simple. Companies with higher margins or larger scale (TCS has both) are better positioned to get aggressive if the industry situation so warrants. That deserves a premium. Valuing companies in same industry with similar growth but differentiated moats, at the same levels will eventually break. This is the risk that HCLTech investors are exposed to now. Irrespective of the absolute direction of IT stocks from here, HCLTech is likely to be an underperformer to TCS and Infosys.

One could argue Accenture has lower margins than TCS, but both trade at similar valuations. But that misses the fact that Accenture has a very strong moat, given its substantially-larger scale/size as compared to TCS and its higher share in consulting revenue.

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