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Reliance Research - India IT Services - Results Preview - Demand Resiliency to Continue Amidst Rising Margin Pressure

Posted On: 2021-10-06 20:54:23 (Time Zone: IST)

In 2QFY22, the NIFTY IT Index outperformed by 11% (YTD outperformance of 14%) to NIFTY. We expect continued strong revenue momentum on the back of deal ramp-ups and sustained deal closure activity across our IT coverage universe. We expect rising pressure on EBIT margin due to higher incentives for employees, step-up in employee onboarding and increased SG&A cost. Recently, Accenture reported 18.6% YoY USD revenue growth in its outsourcing services business, which we believe bodes well 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 IT companies under our IT sector coverage universe.

Deal Ramp-up 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. We expect 3.8-6.6% and 5.4-6.3% sequential growth in CC revenue of the large-cap and mid-cap companies, respectively. We expect deal bookings to remain strong given higher demand for digital services. Further, revenue growth is likely to be broad-based across geographies and verticals.

Accelerated Hiring & Higher SG&A to Weigh on Profitability

We expect the companies under our IT sector coverage universe to report 0-170bps QoQ decline (Except TCS & LTI) in EBIT margin due to: (1) annual salary increment cycle; (2) accelerated hiring (both freshers and laterals); and (3) marginal step-up in investment in sales and capabilities. Notably, TCS, LTI and TechM underwent regular increment cycle in 1QFY22 and the rest are likely to follow in 2QFY22. We highlight higher margin pressure in 2QFY22E, owing to higher employee incentives amidst rising attrition. 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 accelerated attrition is likely to be a medium-term phenomenon, as we expect the demand environment to remain strong over FY21-FY24E. Going ahead, we believe margin acceleration would depend on: (1) improved pricing; (2) operating leverage (double-digit revenue growth); and (3) USD appreciation.

IT Names to Raise FY22 Revenue Growth Guidance & Maintain Margin Outlook

We expect the companies to raise their strong revenue guidance for FY22E on the back of solid deal backlog and buoyant deal environment. We also believe broad-based consensus among the large-cap and mid-cap IT companies regarding acceleration in technology demand. We expect Infosys to raise its revenue growth guidance range to 16-18% vs. earlier guided range of 14-16%. Additionally, we expect HCLT to introduce numerical revenue guidance in the range of 12-14% vs. earlier guidance of double-digit revenue growth. We expect the IT names to maintain EBIT margin outlook amidst rising headwinds. We expect the IT names to invest margin gain that they witnessed in FY21 for capability addition and talent retention, which will aid their market share gain in the medium-term. We also expect accelerated disclosures/commentary on progress of Cloud business.

Key Focus Points - Vertical Outlook, Deal Pipeline & Investment Areas

(1) Management commentary on demand outlook in Manufacturing, Energy, Retail and Travel and Hospitality verticals; (2) Any change in tech spending behaviour by the large US banks and insurers; (3) Progress on large deal closure front and read-across for the mid-cap names from mega employee rebadging deals; (4) Long-term target and current progress on Work from Home model; (5) Any plan for expansion of ecosystem partnership and change in capital allocation policies; (6) Focus areas for investment and capability development; (7) Attrition trend and hiring trends; and (8) Pricing trends.

Our View

Majority of global enterprises are still at 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. Currently, NIFTY IT trades at >30% premium to NIFTY on 1-Yr Fwd earnings basis vs. historical average premium of 7%. We expect multiple re-rating for select IT names given their resilient operating model (low capex and high variable cost structure) strong revenue growth visibility over FY21-FY24E, which warrant premium valuation.

Our Top Results Picks: TechM and HCLT

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