Why you should book profit in Infosys but continue holding HCL Tech

At Portfolio, we have been re-iterating since January that while IT services companies have done an excellent job in the recession year of 2020-21, the disconnect between earnings/growth and valuations pose a risk. The stretched valuations of the sector versus historical levels, alongside earnings growth prospects for the long-term remaining moderate (high single-digit to low double-digit percentage growth), are reasons to stay broadly cautious on the sector. Generally, periods of excess returns in short periods without growth in earnings expectations are followed by periods of sub-par returns.

For example, the TCS stock, after providing returns of 50 per cent in a 6-month period between end March to end September 2018, did not provide any positive returns for the next 2 years from September 2018 levels. Hence, given the excellent returns in the top-4 IT services companies without a corresponding growth in earnings, the case for solid returns from current levels appear dim for investors with a two-year perspective.

Besides this, investors need to note that investments in stocks is not just a function of positive returns in the long term, but also risk adjusted returns – the returns must be commensurate with the risk taken and volatility experienced.

We had given a ‘book profit’ call on TCS on January 24 when the stock was trading at ₹3,304 ( now at ₹3143.15). After originally recommending a ‘hold’ call on Wipro on March 21 when it was trading at ₹410, we recommended ‘book profit’ on the same recently, when it was trading at ₹513. We re-iterate our calls on these two stocks.

Amongst the other big Indian IT companies, we now recommend ‘book profit’ in Infosys as well and a ‘hold’ on HCL Technologies.

Infosys

Infosys in many ways was the best performer amongst the large IT services companies in FY21, delivering the best constant currency revenue growth of 5 per cent (TCS – negative 1 per cent, Wipro – negative 2 per cent, and HCL – 1 per cent). This indicates market share gains by the company in a challenging year. The company also did well to grow its earnings by 17 per cent in FY21 versus 7 per cent in FY20, driven by revenue growth, improvement in operating margins and currency depreciation.

Solid financial performance combined with robust operating metrics, in terms of growth in digital segment and record large deal wins, created a solid base for re-rating in Infosys valuation multiple. Infosys’ valuation discount versus TCS in terms of trailing PE (Price to Earnings) has already reduced to 15 per cent now versus the 5-year average of around 20 per cent, reflecting hopes that Infosys can now possibly become the industry bellwether sometime in the next few years. This was the case in the first decade of the millennium as well.

Given this backdrop, the business outlook for Infosys is the brightest it has been in recent years. However, the stock is up by around 75 per cent since its pre-Covid levels of Jan/Feb. 2020 in a year in which earnings grew by 17 per cent. Much of these positives appear to be priced in at current levels. The valuation premium of the stock to its 5-year average is nearly 60 per cent.

While the valuation premium can partly be justified by its better performance, it cannot be denied that this is also a reflection of liquidity flows from developed markets and investor exuberance. Hence, sustenance of these valuation multiples is unlikely. Alternatively, this valuation could be justified if there is a case for acceleration in long-term earnings growth. As of now, there is no strong evidence of the same. Hence, investors can book profits.

HCL Technologies

HCL Technologies also had a good FY21 despite the pandemic disruptions, with constant currency revenue growth of 1 per cent and 12.5 per cent growth in adjusted EPS , driven by good improvement in EBIT margins, and the benefit of currency depreciation. Deal momentum was strong for the company, lending confidence to growth recovering nicely going forward, after a slowdown in FY21. It expects to remain at the upper end of industry growth in the medium term. The company has also followed a differentiated strategy versus peers by focussing on segments such as products and platforms and has made aggressive acquisitions in this space in the past.

The prospects broadly look solid for the company over the medium term. After its shares being largely rangebound between early 2018 to early 2020, the stock is now up by around 50 per cent from its pre-Covid levels. It currently trades at a trailing PE of 23 times, which is a premium of around 40 per cent over its 5-year average. While it is high, given that the company traded at a higher-than-warranted discounted valuation versus peers in the past, the current premium may not be excessive. The stock also trades at a reasonable one year forward PE of around 18 times. Hence investors can hold the shares.