India IT Services - Results Preview - Seasonally weak quarter; Supply Side Issue to Continue Exerting Margin Pressure

In 4QFY22, the Nifty IT Index underperformed the Nifty by ~6%. Though 4Q is a seasonally weak quarter, we expect a strong revenue momentum on the back of deal ramp-ups, IT transformational spends and sustained deal closure activity across our IT coverage universe. We expect rising pressure on EBIT margin due to higher incentives for employees, wage hike to retain talent amid the high attrition, lower utilization due to aggressive fresh hiring, and higher SG&A cost. Moreover, the Ukraine-Russia conflict has further accentuated the issue with a greater impact on ER&D talent supply. Recently, Accenture reported 28% YoY USD revenue growth in its outsourcing services business, which we believe is a key positive for the Indian IT names. Looking ahead, we expect the deal environment to remain robust backed by consistent technology spend on digital services by the global enterprises. We expect strong end-market commentary from the top 8 companies under our IT sector coverage universe. Despite 4QFY22 being a lean quarter in general, we expect healthy deal flows to drive the revenue growth.

Robust Demand Outlook and Digitalization to Accelerate Revenue Growth

We expect the IT companies under our coverage universe to report strong deal momentum (strong book-to-bill ratio and solid deal pipeline) across most verticals due to a strong demand seen for transformation and digitalization. We expect 3.7-2.7% and 4.7-5.6% sequential growth in CC revenue for the large cap and mid-cap companies, respectively. Further, revenue growth is likely to be broad-based across geographies and verticals. We expect the deal bookings to remain strong, given the ongoing digital transformation trend.

Higher Attrition, Lower Utilization & Supply Side Issues to Impact Margins...

We expect the companies under our IT sector coverage universe to report 40bps QoQ decline in EBIT margin due to: (1) accelerated hiring (both freshers and laterals) amid the high attrition; (2) marginal step-up in investment in sales and capabilities, and (3) lower utilization due to hiring freshers. We highlight the margin pressure in 4QFY22 owing to higher employee incentives amid the rising attrition, while operating leverage and cross-currency would nullify the impact to a greater extent. Thus, we expect a more or less stable operating margin. Though attrition would remain elevated, we believe that it has already peaked out now. We expect cost pressure to continue over the next 2 quarters, while margin would recover in 2HFY23. Additionally, we believe the large cap IT names are in a better position to address supply side concerns compared to their mid-cap peers. We believe the accelerated attrition is likely to be a medium-term phenomenon, as we expect the demand environment to remain strong over FY21-FY24. Going ahead, we believe margin expansion would depend on: (1) improved pricing; (2) operating leverage (double-digit revenue growth); and (3) USD appreciation.

IT Names to Guide for Double digit FY23 Revenue Growth & Maintain Margin Outlook

We expect the IT companies to guide for decent double digit revenue growth for FY23 on the back of a solid deal backlog and buoyant deal environment. We also believe a broad-based consensus exists among the large cap and mid-cap IT companies regarding acceleration in technology demand. We expect Infosys to give FY23 revenue growth guidance of 12-14% and FY23 EBIT margin in the range of 22-24%. We expect Indian IT names to record mid-teen double-digit revenue growth in FY23 and maintain margins around the current level in 1HFY23E, while margins would improve by 50-100bps in 2HFY23E. We expect a decline in the utilization rate due to fresher hirings and a rise in discretionary cost.

Key Focus Points

(1) Revenue guidance, 2) large deal pipeline/bookings, 3) IT budget of clients for the next year, 4) hiring intensity, and 5) attrition trend.

Our View

The IT sector (coverage universe) is set to post another quarter of strong growth with decent CC growth and stable margins despite a seasonally weak quarter and cost pressure, based on (1) increasing speed of digital transformation/shift to cloud, 2) improving deal pipeline, and 3) investment in the hyperscalers/SaaS ecosystem. We expect the IT companies to invest the margin gains that they witnessed over the last 1.5 years for capability addition and talent retention, which will aid their market share gain in the medium term. We also expect accelerated disclosures/commentary on the progress of cloud business. Majority of global enterprises are still at an early stage of digital adoption, which is a huge opportunity for the Indian IT companies. Digital services business is likely to clock 15-20% CAGR in the medium term, led by increased cloud adoption by the global enterprises. We expect the IT players to benefit from potential acquisition opportunities of captive units and vendor consolidation efforts. We expect valuation multiple to remain high, though it has peaked out, hence leaving limited scope for further expansion. The stellar performance of Accenture has further strengthened our positive view on the sector.

Our Top Results Pick: Infosys

Link to the report

Source : Equity Bulls

Keywords

RelianceResearch RelianceSecurities ITServices Q4FY22 ResultsPreview