Calibrating to new normal - 4QFY20E Preview of IT sector - HDFC Securities

IT sector is expected to post 4Q revenue growth in the range of -3% to +2.9% QoQ with IT sector (coverage universe) aggregate growth at +0.3/5.6% QoQ/YoY, at its slowest sequential pace in 13 qtrs. The impact of economic dislocation accentuating in March has led to major supply-side transition for the sector impacting billings. The demand-side factors and the second-order impact (disruptions in clients) will lead to a bigger dent in the ensuing quarter (-12 to 0% QoQ in 1Q est). We expect 4Q margins to be flattish (-12bps QoQ) with the impact of utilisations and negative cross-currency mitigated by INR depreciation.

COVID-19 situation has aggravated at a fast clip and we cut EPS estimates further by ~9/15% for tier-1/tier-2 IT, following 4/7% cut on 18-Mar. Our estimates now factor a deeper impact in Jun-qtr and a gradual recovery over the course of Sep-qtr. For FY21, we now expect the sector to post USD rev/PAT decline of 0.5/4% (following 7.5/3.0% growth in rev/PAT in FY20). Indian IT (tier-1) growth has been at a 500/900bps premium to US GDP growth over 5/10 yrs (800bps prem in CY09 recession). Based on the empirical growth premium (including the Sep-08 to Dec-09 compression period), our growth estimates for the sector triangulates to an annual GDP decline scenario of ~3%. The shape of growth recovery will be the biggest determinant though, as growth premium can dissipate in a protracted recovery. While the uncertainty persists as the sector calibrates, IT index' recent drawdown (20/23% in 1M/3M) supports our constructive stance (Built to last). Our top picks include INFY, HCLT and LTI.

LTI to lead, Sonata, PSYS to lag in 4Q: Within tier-1 IT, TechM is expected to lag growth at -1.6% QoQ, while TCS, INFY, HCLT are expected to post 0.5%, 0.4% (organic) and 0.4% QoQ growth respectively. Wipro is expected to be at the lower-end of its guided range. Within tier-2 IT, LTI is expected to lead growth at 2.9% QoQ while Sonata/Persistent are expected to lag at -3.0/-2.6% QoQ in 4Q. On the operating side, LTI and Mindtree are expected to outperform with QoQ improvement in margins.

Key monitorables include: 1) Demand & sales velocity impact of COVID-19 on key verticals and core geographies, 2) Discretionary services (non-critical) mix/project duration metrics within the revenue pool, 3) COVID-19 impact on service delivery (WFH complexities and regulatory hurdles), 4) Progression/regression in large deal pipeline and virtual framework for pipeline creation and conversion, 5) Mediumterm levers to absorb the demand shock and re-set the cost base, 6) DSO trend and capital allocation (buyback) plans.

Ratings & Outlook: Maintain constructive stance on the sector, despite increased uncertainty. Upgrade Mindtree to ADD (REDUCE earlier), Downgrade Persistent Systems to Reduce (ADD earlier). Maintain BUY reco on INFY, HCLT and TechM and ADD reco on LTI, Mphasis, LTTS and Hexaware.

Source : Equity Bulls

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