Kotak downgrades Persistent Systems, HCL Tech shares post rally; says Infosys, Cyient top IT stock picks

Kotak Institutional Equities said a majority of increase in IT stocks' prices this year has been a function of re-rating, even as FY24 and FY25 growth estimates have declined in the same period, especially for stocks such as Mphasis Ltd and Tech Mahindra Ld. A hope of improvement in fundamentals has not reduced, even after multiple quarters of disappointment, the brokerage said adding that even as the Fed’s move warranted an upward movement in stock prices, the resulting rally was a tad optimistic

The brokerage said Infosys is its top pick among IT services companies, as it expects Infosys' growth to normalise to 9.1 per cent in FY2025 from 2 per cent in FY2024.

"Upside has reduced for HCL Tech following the recent sharp rally; it remains our next pick," it said while suggesting Cyient as its preferred pick in mid-tier. Kotak said there are interesting names among mid-tier, namely Persistent Systems Ltd, but they trade at expensive valuations.

Growth estimates, fair values

Kotak said its current revenue growth and EPS estimates already factor in the positives for FY25, which included soft landing in the US and abating of demand headwinds.

"We increase fair values by 9-20 per cent on rollover and increase in multiples factoring in lower macro uncertainty. The strong rally limits further upside in select stocks. We downgrade HCL Technologies to 'ADD' from 'BUY' and Persistent Systems to 'REDUCE' from 'ADD'," Kotak said.

Kotak said IT services firms faced a tough demand environment in FY2024 due to reluctance to commit to new programs given high economic uncertainty, reprioritisation of spending away from Covid-era priorities toward efficiencies and optimisation, excess in-house hiring and longer sales and ramp-up cycle in mega deals.

These headwinds, Kotak said, resulted in muted revenue growth of 2-5 per cent for large companies and 6-14 per cent for mid-tier names.

"Revenue declined for Wipro, TechM and Mphasis. These headwinds have bottomed out and will incrementally aid demand and revenue growth in FY2025. Our base case already factors these tailwinds and a soft landing for the US economy," it said.

Kotak said the current one-year forward PE multiples are lower but approaching peak one year forward multiple during FY2022. However, forward growth estimates are also considerably lower. Kotak said its FY2026 revenue growth estimates for IT companies are 1-4 per cent lower than its FY2024 growth estimates two years ago.

The domestic brokerage said that the rollover to December quarter and 2 times increase in multiple factoring in lower macro uncertainty following rate cut path laid out by US Fed lead to 9-16 per cent increase in fair values for IT stocks.

"We cut rating on HCLT to an ADD from BUY following 13 per cent stock price increase in the past month. We also cut rating on Persistent to REDUCE from ADD. The stock trades at 33X FY2026E EPS and is expensive after 22 per cent rally in the past three months.

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