Reduce weightage in IT stocks, says HSBC Global; cuts price targets for TCS, Infosys

After providing investors with a massive 40 per cent return in 2021-22, the Nifty IT index is down 5.4 per cent so far this year, and earnings of the two largest companies, TCS and Infosys, have done little to stem the slide.

For investors wondering what’s next, HSBC Global Research warns of likely hurdles that the sector may continue to face going ahead.

“Limited upside risk to revenues and potential margin headwinds skews overall FY23/24 EPS (earnings per share) risks to downside,” the global research firm said.

While the relative defensiveness that the IT sector boasts of is sustained, HSBC’s equity strategists recommend a reduced sector weighting.

The global research firm has affirmed a hold rating for TCS, downgraded Infosys to hold from buy and cut target prices, saying that weakness in the rupee is an upside risk to the stocks.

“We downgrade Infosys to Hold on lower potential market share gains in FY23e, a downward risk to profitability, and limited upside to growth estimates; cut TP (target price) to INR 2,040 from INR 2,225. Maintain Hold on TCS and cut TP to INR 3,760 from INR 4,310.”

The export-oriented Indian IT sector typically stands to gain from a weaker exchange rate, with a large component of big firms’ earnings being in US dollars.

While the IT sector remains relatively attractive, the research firm believes that at a time when valuations are “not undemanding”, the little upside potential for growth and the downside risk to margins constrain the room for IT stocks to head higher.

HSBC Global Research pointed out that IT firms’ cloud transformation projects have a long gestation period and cannot be hurried.

“Corporates have multi-year plans for transformation and while this provides longevity to growth, we are not seeing the rush for transformation that we saw in 1H21 or 2H2020. Hence, we see FY23 estimates as already rich.”

Moreover, any shocks on the macro-economic front due to geopolitical developments could hit near-term growth, HSBC said, adding that while transformational projects were not likely to be cancelled, they could face delays.

BASE NOT IN FAVOUR

A key negative cited by HSBC Global Research was an unfavourable base effect that would come into play for the IT sector.

In the financial year gone by, the revenues of the top-5 Indian IT companies stood at $82 billion, clocking a growth of 14 per cent while adding $10 billion in incremental revenues, the research firm said.

“This is 2x the past 10-year run-rate of $5 billion, thanks to a favourable base and a post-pandemic rush for tech transformation by clients. In FY23e, at our current estimates of 12-13% growth, the incremental revenue run-rate is already higher than in FY22 (exhibit 1), despite the absence of a favourable base effect and mega-deals.”

MARGIN BLUES

HSBC Global Research warned of a precarious situation when it came to margins, saying that since the advent of the COVID-19 pandemic, IT companies had a margin tailwind of 600 basis points due to improvement in several operating metrics.

However, only around 100-150 basis points of this were retained while the rest of the margin cushion was eroded by wage inflation and sub-contracting costs, the firm said.

While the wage pressures may ease in the current financial year, the boost experienced during the pandemic may also reverse, exerting downward pressure on margins.

“We reduce target valuation multiple by 10% (from 35x to 32x) to factor in the FY23/24 risk to earnings.”