Infosys' valuation gap with TCS set to narrow further after strong Q2 show

Sharp Q2 outperformance, growth guidance could shrink the discount to 10 per cent from 30% at the start of the year

After a strong September quarter performance and higher revenue and margin guidance by Infosys, the valuation gap between India’s second-largest information technology (IT) services company and market leader Tata Consultancy Services (TCS) is expected to be bridged further.

The valuation gap — at 30 per cent at the start of calendar year 2020 (CY20) — has come down to 15 per cent. It is expected to fall further.

Analysts at Motilal Oswal Research expect the valuation divergence to narrow to 10 per cent, given that Infosys has outperformed TCS in the first half of 2020-21 (FY21) and is on its way to an industry-leading performance in FY21 among tier 1 IT companies. 

With constant currency growth of 2.2 per cent in the quarter, the company outperformed TCS on the revenue growth parameter for the sixth quarter on the trot. 

On the margin front, TCS outscores Infosys. But the latter has been bridging the gap. 

In the June quarter of 2019-20, the margin gap stood at 370 basis points (bps), clearly tilted in favour of TCS. While TCS has improved its margins since by 200 bps to 26.2 per cent, the margin gains for Infosys have been even higher at 480 bps to 25.3 per cent.

Analysts believe the margin differential between the two at about 90 bps is expected to remain in the near term, given the multiple margin headwinds, including salary hikes and travel costs. 

While margin gains are a key rerating trigger, Suyog Kulkarni of Reliance Securities believes Infosys will focus on achieving strong revenue growth, given the opportunities in digital services. He says that in case the company manages to sustain its growth outperformance over the next few quarters, the valuation discount to TCS could be bridged. 

Recent growth triggers for Infosys have been investments to boost its capabilities over the past two years, which, coupled with acquisitions, especially in the digital segment, have helped it get a good share of digital deals. 

In addition to its inorganic approach, execution, too, has been better than TCS. Moreover, the biggest overhang for the company was the frequent leadership changes which were addressed when Salil Parekh was appointed in December 2017.

While there may not be outsized returns from the Infosys stock which has gained 33 per cent over the past three months, analysts expect investors to make money over the long term, given the resilience in technology spends and digital growth opportunity.