IT Sector Wave Ahead: These 2 IT Mid Caps Could Become Next HCL, TCS, Says Edelweiss

After promising Q2 results from TCS (Tata Consultancy Services) and Infosys, the IT space is looking like an attractive bet due to the digital transformation among businesses induced by COVID-19. Most names in the sector are near their record highs but analysts are expecting earnings growth to be robust in the coming years.

Sandip Agarwal, Research Analyst at Edelweiss talking to CNBC-TV18 about the uprise in IT space, said that he has placed high multiples to the whole sector because he believes that "we are in a very big technological upcycle." He added that it is best to upgrade the multiples at the beginning of the cycle to capture the upside.

The beginning of another tech upcycle

On being asked of the high price target of IT companies (Rs 1,850 price target for Infosys, which is 55 percent higher than Thursday's all-time high of Rs 1,186), Agarwal explained that in the previous IT company upcycle of 2009-16, which was led by IMS (infrastructure management services), TCS had only 8% revenue from IMS at the beginning of 2009, while HCL had 12% revenue. Revenue from the segment grew at 28% and 38% CAGR for the next 6 years, for the two IT companies respectively. In comparison, the overall growth of TCS and HCL at 7-year CAGR was 16% and 18% PAT CAGR.

"The jump in market cap during this period was 10x for TCS and 15x for HCL, so you can imagine that 15% revenue growth and 18% PAT growth can lead to this kind of expansion."

He added that back in 2009, the forward multiple was also 40-45x because of the higher than expected PAT (Profit after Tax) reported every quarter by IT companies that even surprised analysts.

"So I would say that the surprise which you have seen yesterday (from Infosys' earnings), you will see for the next 10-12 quarters and everyone will keep being wrong on estimated earnings."

"The wave is very big. It is very difficult to estimate the wave," Agarwal said explaining that no other disruptions seen in the last 20 years has been tech-friendly like COVID-19.

IT support companies are expected to benefit from core transformation, higher cloud adoption, and digital adoption of businesses around the world.

2 Midcaps that could see their market cap multiply

When asked about what his picks would be in the IT segment, Agarwal said he would bet on HCL Technologies for the highest returns, followed by Infosys and TCS.

In the mid-cap segment, he picked L&T Infotech (LTI) and Mindtree Ltd, to which he added "I would like to make a bold statement that I see Mindtree where HCL Tech was in 2009 and I see LTI where TCS was in 2009. I think in the next 10-15 years, you will see similar market caps for both."

Infosys Q2 raises optimism for the IT sector

Infosys, which surprised investors in the previous upcycle with double-digit growth in profits every quarter, hit a new all-time high on 15 October, a day after yet another surprising quarterly results.

The company reported a 14.4 percent sequential growth in consolidated profit at Rs 4,845 crore for the September-ended quarter. The company revised its revenue growth guidance upward to 2-3 percent in constant currency for the financial year 2020-21, from 0-2 percent earlier. The full-year operating margin guidance was also revised upward to 23-24 percent against 21-23 percent earlier.

Infosys added five clients in the $100 million bucket while total deal wins for the quarter stood at $3.15 billion, its highest ever in one quarter. The large deal wins were a highlight for brokerages as it showed clear signs of growth potential for the IT segment amid digital transition.