IT Q3 Preview | Healthy topline likely despite seasonal factor; midcaps may outperform largecaps

Market Outlook

Healthy deal flows are likely to drive revenue growth even though December is generally a lean month due to year-end holidays

Sunil Shankar Matkar

January 05, 2022 / 01:24 PM IST

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Technology companies will kick off the December quarter earnings season next week with Tata Consultancy Services, Infosys, HCL Technologies and Wipro releasing their numbers. Experts expect revenue growth to be healthy despite the seasonality factor, driven by a robust demand outlook amid digitalisation. Midcap IT companies are likely to continue to outperform large-cap firms.

The Nifty IT index surged 60 percent in 2021 and gained 10.5 percent in the quarter ended December, outperforming other sectors as well as the Nifty 50, which fell 1.5 percent during the quarter due to high valuations and US Federal Reserve tightening.

Tech Mahindra was the biggest gainer among IT stocks in the December quarter, rising 30 percent, followed by L&T Infotech with a 27 percent gain. Mindtree, Wipro, Infosys and Coforge rallied 12-14 percent, while HCL Technologies was up 3 percent. TCS underperformed, falling 1 percent.

Top line performance

Analysts expect the third quarter (October-December) of FY22 to be another strong one for IT companies as large-caps (tier-1) are expected to report 2.5-4.5 percent revenue growth in constant currency terms, and midcap IT firms (tier-II) are set to clock 3.5-6.5 percent top line growth in constant currency terms, driven by healthy deal flows. Dollar revenue growth is likely to be 2-3.3 percent quarter-on-quarter. December is generally a lean month due to Christmas and New Year holidays.

“Despite the impact of furloughs, we forecast extremely strong revenue growth led by high discretionary and continuing transformation spends,” Kotak Institutional Equities said. “Wipro, Tech Mahindra and HCL Technologies will likely deliver around 4.5 percent growth in constant currency. We forecast Infosys’ growth at 3.7 percent and TCS to deliver modest 2.6 percent QoQ growth.”

The brokerage said mid-tier companies may deliver revenue growth rate of 5-6 percent in constant currency, with YoY growth of 20-34 percent.

Companies will have cross-currency headwinds of 20-90 basis points due to the dollar’s appreciation against the pound, the euro and the Australian dollar, it said. One basis point is equal to one-hundredth of a percent.

Elara Capital expects tier-1 IT service companies to report organic growth in the range of 2.5-4 percent QoQ in constant currency.

“Average revenue growth in USD terms is expected to be 3.1 percent QoQ, dragged by negative cross-currency impact of around 65 bp QoQ. Growth momentum has been robust despite Q3 seasonality and strong base (more than 4 percent CQGR over the past four quarters),” Elara said. CQGR refers to compounded quarterly growth rate.

The growth momentum is supported by healthy deal flows (small and mid-sized), a better annual contract value-to-total contract value trajectory, and continued offshore- and volume-led growth, the brokerage said.

In the midcap space, “Mindtree, L&T Infotech and Persistent Systems are expected to lead growth within the pack and would post mid-single-digit to high single-digit sequential growth,” said Elara.

Deal wins

Deal wins are expected to remain healthy, but reported total contract values (TCV) may not reflect the strength in demand fully.

“We expect deal intake to remain healthy across companies in Q3,” said Emkay Global.

However, TCVs may remain steady as deal tenures have become shorter with clients wanting digital transformation projects to be implemented in a short span rather than signing large, longer-tenure deals, which follow lengthy due diligence and legal processes, Emkay said.

The deal pipeline is robust across the IT sector, driven by an uptick in contracts related to cloud adoption, digital transformation and customer experience transformation, the brokerage added.

Accenture’s recent results created buoyancy among IT companies, indicating that growth in tech will continue and remain upwards.

FY22 guidance

Infosys and L&T Technology Services are expected to revise their full-year constant currency revenue growth guidance upwards.

“We expect Infosys to tighten the guidance band to 17-17.5 percent from 16.5-17.5 percent earlier,” said Kotak.

Infosys started the year with a revenue growth guidance of 12-14 percent. HCL Technologies estimated double-digit revenue growth.

“We expect HCL Technologies to deliver revenue growth of around 12 percent in constant currency for FY22. L&T Technology raised the revenue growth guidance after September quarter results to 19-20 percent. We believe it may further up the guidance to 20-21 percent,” Kotak said.

Emkay expects Infosys to revise its FY22 revenue growth guidance to 17.5-18 percent year-on-year, while IDBI Capital expects Infosys to up the guidance to 18-19 percent.

According to both brokerages, Wipro may project a 2-4 percent QoQ revenue growth in constant currency for the fourth quarter of FY22.

Operating performance

The earnings before interest and tax margin is expected to be steady on a sequential basis and lower on a year-on-year basis due to the high base in the year-ago quarter. The attrition rate is expected to remain on the higher side.

There were many benefits in December such as the deferment of wage revision (except for TCS), negligible travel costs and a pullback in discretionary spending. Companies have rolled out wage increases twice since the December 2020 quarter, which reflects in YoY decline in margins.

The margin picture will be steady on a sequential basis with primary headwinds emanating from the backfilling of attrition with lateral recruitment, which costs 25-30 percent more, a decline in utilisation rate as companies load up on fresher hiring, and a creeping rise in discretionary costs, Kotak said.

“These will be offset to some extent through further tightening of operations,” said Kotak, adding all companies will report a YoY decline in EBIT margins.

On the bottom line, Motilal Oswal expects tier-I tech companies to deliver growth of about 11 percent YoY and about 6 percent QoQ.

“Tier-II players are expected to report a robust PAT growth (around 23 percent YoY and 6 percent QoQ), driven by strong revenue growth, but partially offset by lower EBIT margins,” it said.

Key factors

Deal wins and the deals pipeline, outlook, attrition and hiring trends, commentary on CY22 IT budgets, demand environment in banking, financial services and insurance (BFSI), manufacturing, retail, and communications, the pricing environment and digital trends are the key factors to watch out for.

Stocks to bet

Emkay’s pecking order is Infosys, TCS, HCL Technologies and Tech Mahindra among tier-1 companies and Route Mobile, Mphasis, Firstsource Solutions, e-Clerx Services, Persistent Systems and Birlasoft in midcaps.

Motilal Oswal prefers tier-I companies, given their relative valuation attractiveness and tendency to narrow down the valuation differential over time.

“Among tier-I players, we like Infosys, HCL Technologies, and TCS. In tier-II, we prefer L&T Technology Services and Zen Technologies.

Elara Capital prefers Infosys, Tech Mahindra and HCL Tech among tier-1 firms and Mphasis among mid-tier IT companies. IDBI Capital prefers Infosys and Wipro among large-caps and Zensar, Birlasoft and Tech Mahindra among midcaps.

Kotak is still constructive on the space, although returns will moderate from here.

“Infosys, HCL Technologies and Mphasis are our top picks,” Kotak said.

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