Morgan Stanley chose to remain selective on mid-sized technology companies as the global investment bank assesses feasibility of growth estimates against their elevated valuations.
The financial services provider upgraded Mindtree Ltd. to ‘overweight’, saying it will surprise the street on revenue growth as well as margin. It upgraded Cyient Ltd. to ‘equal-weight’, while downgrading L&T Infotech Ltd. and Mphasis Ltd., according to a note.
“Mid-cap IT stocks in our coverage are up 130-250% since their lows in March 2020, with Cyient up the most (250%), followed by L&T Infotech (165%), Mphasis (140%), and Mindtree (130%) versus the Sensex’s 82% rise,” Morgan Stanley said. “This is driven by earnings upgrades, leading in turn to expansion in valuation multiples as well. We think returns could moderate from here – hence, it makes sense to be selective.”
According to Morgan Stanley, revenue growth in FY22 will make a strong comeback with better comparisons and tailwinds from a technology upcycle. The growth, it said, will be dictated by new deal wins in the coming quarters along with acceleration in other channels (such as new logo additions, mining of existing accounts, and expansion into Europe as a geography, where mid caps are relatively less entrenched compared to large-caps).
“Thus, we think that investor discussion will now concentrate on how much of the growth is feasible,” the global research firm said. “Even with tailwinds to growth, the implied compounded quarterly growth rate — on our numbers as well as consensus — is below the companies’ peak Compounded Quarterly Growth Rate in their recent past. This may pose upside risks if execution is sustained.” Mindtree’s consensus estimates, according to the note, may have the potential to surprise on the upside.
Besides, Morgan Stanley sees margin to have likely peaked for most companies, making it “less of a talking point in 2021”.
“That said, momentum in margins may remain in a tight band even with planned investments. The margin band for Mphasis may have an upward bias, L&T Infotech has had a history of operating above that band in high growth periods,” Morgan Stanley said. “Our scenario analysis for Mindtree with reasonable assumptions indicates that moderation in margins from current levels may not be as high.”
Still, Morgan Stanley highlighted potential tax changes in the U.S. affecting clients’ sentiment and decision-making cycles, client-specific challenges, adverse currency movements as some of the key risks.
Here’s Morgan Stanley’s stance on four Indian mid-cap IT stocks...
Mindtree
- Upgrades to ‘overweight’ from ‘equal-weight’; hikes price target to Rs 2,100 apiece from Rs 1,645.
- Growth profile has been broadening and management has initiated several steps to target industry-leading growth.
- Steps taken are in the right direction to fire up the growth engine.
- Expects U.S. dollar revenue CAGR of more than 15% over FY21-23.
- Expects revenue growth to surprise on the upside.
- Expects margin of 21-22% in FY22-23, driven by strong revenue growth, normalisation of out-of-turn expenses and efficiencies.
Cyient
- Upgrades to ‘equal-weight’ from ‘underweight’; raises price target to Rs 630 apiece from Rs 450.
- Issues in aerospace defence could have bottomed in the third quarter and may not decline further, though growth may take several quarters to return.
- There is momentum across the communications vertical, which is now the largest by revenue contribution.
- Addition of new capacity in design-led manufacturing business can entail annualised revenue of $250 million, while the current run-rate is only around $100 million.
- Expects margin to expand to more than 12% in FY22-23 from 10% in FY21.
L&T Infotech
- Downgrades to ‘equal-weight’ from ‘overweight’; cuts price target to Rs 4,000 apiece from Rs 4,600.
- Expects improvement in revenue growth trajectory with stable profit margin.
- Well positioned to capture the cloud opportunity with the ambition to catapult the current cloud business run rate of $180 million to $1 billion in the next three years.
- Despite strong revenue growth and stable margin profile, it trading at a premium to TCS is unwarranted.
- Not turning underweight because growth undercurrents are strong.
- Expects U.S. dollar revenue CAGR of 17.5% over FY21-23E.
- Can turn overweight again if valuations return to more reasonable levels.
Mphasis
- Downgrades to ‘equal-weight’ from ‘overweight’; cuts price target to Rs 1,650 apiece from Rs 1,840.
- Direct core engine to continue to drive growth but will be partly offset by decline in DXC Technology's business and moderation in growth in digital risk.
- Growth remains strong in direct core business with large deal engine delivering on all fronts.
- Building in average margins of 17% for FY22 and FY23.
- One-year forward P/E of 22.3x, even though at a discount to TCS provides limited upside from current levels.
- Expects U.S. dollar revenue CAGR of 11-12% over FY21-23E.
- Can turn overweight again if DXC business revenue run rate turns out to be higher than expectations.
- A strong pullback from current levels may provide valuation comfort.
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