Outlook on IT Firms. Which stock is your best bet among the top four IT services companies?

In a quarter that has seen demand for IT services pick up dramatically, four of India’s large IT services companies have shown that the markets expectation of their performance was right.

Tata Consultancy Services , Wipro , Infosys and HCL Technologies have all reported sequential rise in revenues during the quarter ended September 30, 2020.

Infosys, TCS and HCL Tech have announced interim dividends, while TCS and Wipro have announced share buybacks at the end of the quarter. This shows that these companies are generating, and expect to generate, decent cashflows in the coming quarters. All four have also restarted pay hikes in the second half of 2020-21 and have started paying out variable incentives to employees. This shows that the uncertainty surrounding their businesses, witnessed when the Covid-19 pandemic broke out, is fading away.

What are the future prospects for these four companies?

How they fared

One common theme across TCS, Infosys, Wipro and HCL Tech was the growth in revenues from retail clients. This segment was affected the most in the quarter ended June 30, 2020.

TCS, Infosys, Wipro and HCL Tech saw dollar revenues rise sequentially by 12 per cent, 10.6 per cent, 5.6 per cent, and 8.4 per cent, respectively. The pick-up in revenues shows that clients are trying to adapt to the new way of doing business under the cloud of the pandemic.

Another common theme was sequential growth in the financial services vertical. This was another segment that was impacted in the previous quarter.

Although HCL Tech did see muted sequential growth (2.6 per cent in dollar terms) in financial services, the trend was of increased technology spends by clients in this vertical.

TCS, Infosys and Wipro saw sequential revenue growth in dollar terms of 9.3 per cent, 7.8 per cent and 5.4 per cent, in that order. Some of this increased spending was on account of clients adapting their systems to distribute the large stimulus package (unveiled in the US and Europe) to their customers.

Life sciences and healthcare was also vertical that saw robust sequential revenue growth across all four companies. It is difficult to tell whether this was caused due to the pandemic or whether this is a sustainable trend.

But the larger theme that unfolded in the past six months for TCS, Infosys, Wipro and HCL Tech was clients pushing to adapt cloud and digital technologies into their core business operations, including those who had been sitting on the fence.

TCS believes the migration and adoption of cloud technologies bodes well for future revenue growth as this will push clients to adopt native cloud capabilities such as artificial intelligence, internet of things and machine learning. It also believes that this is the beginning of a multi-year technology spending cycle.

Infosys and HCL Tech upgraded their revenue and margin guidance for FY21, and Wipro restarted its practice of giving quarterly revenue guidance.

TCS does not give any revenue or margin guidance. Based on the management commentary, only Infosys is expected to post year-on-year revenue growth in constant currency terms for FY21.

In the next couple of years, the rush to adopt digital and cloud technologies is going to pay off well for all four companies.

But TCS and Infosys will benefit the most, followed by HCL Tech and Wipro.

Q2 results: IT majors set to see robust numbers after two quarters of Covid-led disruptions

Stock performance

In anticipation of the rebound in revenue growth, the shares of TCS, Infosys, Wipro and HCL Tech have touched record highs. This has been the general trend for the IT services space. TCS has risen nearly 70 per cent from the lows of March 2020, while Infosys, Wipro and HCL Tech have more than doubled since then.

When the results were announced over the last 10 days, these stocks did shed some of the gains as investors booked handsome profits. But they still trade at elevated price-earnings multiples compared with their historic levels. However, considering the current economic circumstances, investors bet that only IT services can assure them of certain returns. To an extent, that justifies high valuations.

Options before investors

Infosys seems to be the best bet for investors who are looking at investing in the IT services space.

The company has bagged some big deals in the recent past, and when these deals start delivering revenues, the firm will witness good revenues growth. At near 27 times its trailing 12-month earnings, the stock does seem expensive, but the future looks rosy.

Then comes TCS.

The company is content at delivering profitable growth. It is trading at a very expensive 34 times its trailing 12-month earnings.

No doubt the company is one of the largest IT services players in the world. But considering the company is not expected to return to its FY20 revenue levels in FY21, there is too much exuberance priced into the stock.

Investors should buy the stock if there are corrections.

Among Wipro and HCL Tech, investors should prefer HCL Tech. HCL Tech is churning out a lot of cash at the operating level and the market seems to continue to undervalue this stock.

Wipro is making many changes across its organisation through its new CEO. This could work in the long run, but investors should wait out and see if his plans end up delivering profitable growth.