Edelweiss report on InfoTech sector with list of best large-cap & mid-cap stocks to buy now

Perspective on IT Sector: Valuation correction of 17-49% largely factors in known concerns; Near-term company guidance/commentary is likely to stay unchanged. We expect recovery with Infosys/techm and LTI/LTTS as top picks

“We suffer more often in our imagination than reality” – Seneca.

Global macro-concerns may be as likely and as severe as street expects or may be more/less, we don’t know. But valuation correction is likely factoring it in already in nearterm at-least, because

a) IT stocks valuations have corrected 17%-49% and stock prices has corrected 9%-42% in last 6 months (since mid-Dec 2021). Nifty IT index valuation has corrected by 27% and price by 21%. About 2 quarters back we made a case that valuation drivers have peaked, now looking at same drivers we believe that valuations are in a reasonable band now (though at the upper end of the band, rather than lower). For example: Infosys is now trading at 23x 1yr Fwd EPS and 21x 2y Fwd EPS (which given the pre/post-pandemic change in RoCE to 38% in FY22 from 32% in FY20 looks reasonable).

b) We believe, bulk of margin pressure is pending. However, margin pressure related concerns is already reflecting in guidance/commentary and has led to street estimates cut post-4QFY22 results. Therefore revenue est. cut was 2-4% in most cases but EPS est. cut was up to 7-9%.

Therefore, we believe 2 of 3 legs – 1st leg, margin related and 2nd leg, cost-of-capital related – price corrections are mostly done. Yield gap (between 10Yr G-Sec yield and IT index earnings yield) is now at last 12 years (post-Lehman crises) average level. It may undershoot (we don’t know), but atleast it’s now at reasonable level (v/s 5-8 months back). 3rd leg (revenue growth cut related leg) is likely to play out over elongated period (2QFY23 onwards).

c) We believe, revenue cut related earnings impact is still pending which may play out elongated period. Consensus estimate is building 12-17% revenue growth for large caps and 16-22% growth for mid-caps. in near-term, we do not expect revenue guidance cut in post-1QFY23 results and we believe management commentaries may become cautious but more likely to re-iterate strong demand outlook (after all business momentum do not reverse as quickly as stock market). So, in near-term there is trading opportunity, though too early to say all is well.

~2 qtrs back, we made case that when we disaggregate growth factor then FY22 growth has large component of deferred demand which is not recurring. Excluding deferred demand part, sustainable growth (from base trend rate + accelerated digitalization) is around 11- 14% only (for large cap) with mid-caps 2-5% higher than large caps. So, there is room to cut revenue estimates further by 3-4% (without factoring latest macro-concerns).

EWM Top Picks: Based on valuation correction and expected likelihood broadly unchanged guidance/commentary in 1QFY23. Our preferred pick to play IT stocks in near terms is Infosys (valuations corrected 26%, price by 18%) and TECHM (valuation down 38%, price – 32%) among large caps. Among mid-caps preferred picks are: LTI (valuation -49%, price – 42%) and LTTS (valuation -33%, price -23%). Under volatile/uncertain scenario, we prefer large caps or large mid-caps over small caps.