India IT Services - Results Preview - Cross Currency Headwinds and Supply Side Issue to Continue Impacting Margins

Posted On : 2022-07-06 21:36:23( TIMEZONE : IST )

India IT Services - Results Preview - Cross Currency Headwinds and Supply Side Issue to Continue Impacting Margins

Mr Mitul Shah, Head Of Research at Reliance Securities.

In 1QFY23, the Nifty IT Index underperformed the Nifty by ~12%. As 1Q is a seasonally strong quarter, we expect a strong revenue momentum on the back of deal ramp-ups, cloud migration and digital technologies, IT transformational spends and sustained deal closure activity across our IT coverage universe. However, cross currency headwinds to the tune of 100-200bps would impact revenue performance. We expect rising pressure on EBIT margin due to higher employee incentives, wage revision, retention cost, visa cost, lower utilization due to aggressive fresh hiring, and higher SG&A cost. Also, cross-currency headwind would have a negative impact on margins this time. Recently, Accenture reported 19% 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. However, pace of growth would moderate in 2HFY23 with likely slowdown in US economy and few other major markets. We expect management to maintain growth guidance broadly while margin pressure may lead to downward revision to margin expectation for few companies. We expect healthy deal flows to continue in 1HFY23.

Stable Demand Outlook and Digitalization to Support 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 in 1HFY23 due to a strong demand seen for transformation and digitalization, while demand would moderate 2HFY23 onwards. We expect 2.4-3.7% and 2.5-3.7% sequential growth in CC revenue for 1QFY23 for the large cap and mid-cap companies, respectively. Further, revenue growth is likely to be broad-based across verticals. We expect the deal bookings to remain strong, given the ongoing digital transformation trend.

Lower Utilization & Supply Side Issues to Impact Margins, but Attrition to Peak Out now

We expect the companies under our IT sector coverage universe to report 47bps 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 (4) higher S&GA cost, due to visa cost and increasing travel expenses. We highlight the margin pressure in 1QFY23 owing to higher employee incentives amid the rising attrition and cross-currency headwind. We expect companies with higher EU exposure to face stronger cross-currency headwind due to likely weakening of GBP and EUR against USD. 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 with moderation in attrition in 2HFY23 and would stabilise. Additionally, we believe the large cap IT names are in a better position to address supply side concerns along with better pricing power compared to their mid-cap peers. Going ahead, we believe margin expansion would depend on: (1) improved pricing; (2) operating leverage (double-digit revenue growth); and (3) currency movement.

IT Names to Maintain FY23 Revenue Growth Guidance

We expect the IT companies to maintain revenue guidance for FY23 on the back of a deal backlog and healthy deal environment. We also believe a broad-based consensus exists among the large cap and mid-cap IT companies regarding better technology demand. We expect Infosys to maintain FY23 revenue growth guidance to 12-14% and EBIT margin in the range of 22-24%. We expect Indian IT names to record low-teen double-digit revenue growth in FY23 with minor moderation in margins in 1HFY23E due to cost pressure and currency headwinds, while margins would recover by ~50bps 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, (4) hiring intensity, and (5) attrition trend

Our View

The IT sector (coverage universe) is set to post another quarter of healthy growth with decent CC growth despite cross currency headwinds and cost pressure, based on (1) increasing digital transformation/shift to cloud, 2) healthy 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 2 years for capability addition and talent retention, which will aid their market share gain over the medium term. We also expect accelerated disclosures 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 for long term. Though FY23E revenue growth outlook for the sector remains strong, FY24E revenue growth would see moderation amid uncertainties on global business environment and worsening macros. We believe high salary inflation in developed markets, increasing travel expenses and higher visa costs would impact margins, despite some relief from better pricing. Post recent price correction, valuations are now below the 5-yr avg and further valuation contraction is unlikely. With double digit revenue growth and likely margin recovery 2HFY23 onwards, we remain positive on the sector despite near-term challenges.

Source : Equity Bulls


India ITService Q1FY23 ResultsPreview RelianceSecurities