TCS downgraded to 'sell'; bet on Infy, HCL: CLSA

Nimish Joshi, IT analyst, CLSA explains to CNBC-TV18 that TCS was downgraded to 'sell' due to a mismatch between the Street's expectations and reality. The analyst also recommends bet on Infosys and HCL on low expectations and strong quarterly results.

Below is an edited transcript of the analysis on CNBC-TV18.

Q1: In today's note you have downgraded TCS. You had an 'underperform' rating on TCS. Why have you issued the call now to 'sell'? What prompted it?  How are investors reacting to your 'underperformer/sell’ call on TCS, because the earnings have been very strong? Are they willing to let go off the stock and exit it?

A: We issued this in today's report - Fit For the Future. It essentially has three key points and I will explain the framework used while downgrading TCS. Firstly, we think revenue growth is going to be challenged and a company as big as TCS, though I must admit it has done spectacularly well, I think going ahead there could be a mismatch between reality and the Street’s expectations. To grow at high levels level requires a lot of sacrifice and in last two-to-three quarters TCS has somewhat disappointed on margins.

To really go up from hereon, the company needs to perform well on revenues as well as margins of which we are a bit skeptical and that brings us to the valuations. The stock is trading at 17-17.5 times and in the report, we have outlined that the fair valuation range for tier-1 Indian IT stocks should be 12-15 times.

So we see some downside on the valuation front as well. Using that framework, we have issued a downgrade. We already had an ‘underperform’ recommendation, but now we would advise investors to get out of TCS completely.

A point that we missed is to at the absolute market cap of TCS which is close to USD 50 billion which is equal to the sum of Infosys, Wipro as well as HCL and IT services is still a labour-arbitrage business. We do not think it is a game of absolute winners. Over time rivals tend to cut down your advantages. So taking all these considerations, we have downgraded the stock to ‘sell’.

Q: Overall, what is your perspective on the IT sector as an investment call because technology as an investment opportunity has become less attractive than what it was? Would you be downbeat on the sector and what would be your pecking order be in terms of stocks you would underweight on with respect to the top four?

A: I agree with you. Definitely it is no longer a secure investment thesis and it is not very difficult to understand why. During the last ten-to-twelve years, the big disruption in IT services was offshore delivery and Indian IT companies were at the beneficial end of that. Today, it is no longer sufficient to have offshore delivery but a necessary condition. So, the incremental market capital is going to be tough especially when you have global companies with a big offshore presence. That is why IT is no longer a secure investment thesis.

Now if you ask me the pecking order, since IT is such a big weight on the MSCI India that investment portfolios would want to have, we would recommend being with Infosys and HCL. Yes, Infosys has not done well, but it is trading at 13 times at one-year forward valuations, expectations are low and even if there is a quarter of revenue growth probably in line with TCS you will suddenly have this surge where investors would want to shift money out of TCS to Infosys. At least to some extent, that could close the valuation gap. So, there is a possibly upward discontinuity in financials at Infosys which has not been seen at TCS.

Though we have accorded a 'underperform' recommendation on both HCL and Infosys, HCL after its good performance in the past couple of quarters has been attracting a new set of investors. When a company does that, the stock does get a long rope, so even if there is a quarter or two of not-so-great results, investors would want to stick with the stock. On a six-to-nine months' perspective for India-focused investment portfolios, I would recommend with HCL and Infosys.