Q3FY23 IT Preview: Soft Quarter; Margin Recovery To Continue

Emkay Global Financial Services has released a note on the earning expectations for the Indian IT companies for Q3FY23. The research house expects revenue growth momentum to likely moderate in Q3 due to furloughs, lower number of working days, deferred spending by few clients, and increased cautiousness among clients amid macro uncertainties.

Emkay Global expects revenue growth of 0.8-3.7% in constant currency QoQ for Tier-1 companies and of -0.4% to 3.4% for mid-cap companies. Emkay Global expects Infosys and HCL Tech to retain their guidance of 15-16% CC YoY revenue growth, 21-22% EBIT margin and 13.5-14.5% constant currency revenue growth, 18-19% EBIT margin for FY23, respectively.

Wipro is expected to guide for 1-3% CC QoQ revenue growth for Q4. Nifty IT index gained ~6% in the last 3-month, largely in line with the broader market indices. Risks of recession and potential cut in FY24 revenue remain; however, margin resilience and weak rupee would limit earnings cut.

Seasonal factors and macro uncertainties to weigh on growth: Emkay Global expects revenue growth momentum to moderate in Q3 on account of furloughs, lower number of working days, deferred spending by few clients, and increased cautiousness among clients amid macro uncertainties and high inflationary environment. Within the coverage, they expect the constant currency revenue growth of 0.8% to 3.7% for tier-1 companies (cross-currency impact of 20-50 bps on reported USD revenue) and of -0.4% to 3.4% for mid-cap firms (cross-currency impact of 10-30 bps on reported USD revenue). Emkay expects the usual seasonality in H2 growth to be amplified by slower decision making and weak discretionary spending due to macro uncertainties.

As per Emkay Global Infosys is likely to retain its 15-16% CC revenue growth and 21-22% EBIT margin for FY23. HCL Tech is also likely to retain its 13.5-14.5% constant currency revenue growth and 18- 19% EBIT margin guidance. Wipro is expected to guide 1-3% constant currency QoQ revenue growth for Q4FY23. Coforge is likely to increase its CC revenue growth guidance to at least 21% (currently at least 20%) while retaining its adjusted EBITDAM guidance of 18.5-19% for FY23. Deal intake is likely to reflect the elongated sales cycle and is more skewed towards cost efficiency and takeout deals.

Rupee depreciation and moderation in attrition to help improve margin sequentially: Except for LTIM, EBIT margin is likely to expand by 20-100 bps sequentially for Tier-1 companies and 20- 50bps for Tier-2 companies on account of operating efficiencies, employee pyramid rationalization, moderation in attrition, and rupee depreciation. LTIM margin is expected to be impacted by one-off costs related to merger integration. The EBITM has a further scope of upside in Q4FY23 for most companies on account of flattening employee pyramid, better utilization, sub-con optimization, and weak rupee.

Key monitorables: 1) CY23 IT budget; 2) FY23 revenue growth/margin guidance; 3) deferment or cancellation of projects due to macro uncertainties, high inflation, and supply-chain disruptions; 4) management commentary on the changing nature of deals (cost takeouts vs. business transformation) and potential impact on tech spending from high inflation and economic slowdown; 5) demand trends in key verticals such as BFSI, retail, manufacturing, and communications; 6) segments exhibiting weak demand trends; 7) deal intake/pipeline; 8) pricing environment; and 9) attrition.

Deal intake may moderate a bit amid macro uncertainties: Emkay Global expects the deal intake to reflect the elongated sales cycle and be more skewed towards cost efficiency and takeout deals with a focus on faster ROI projects. Management commentary on the deal pipeline, decision-making cycle, re-prioritization of spending, softness in discretionary spending, and CY23 IT budgets should be important to gauge confidence on near-term growth visibility. Deterioration in the macro situation may drive vendor consolidation and cost takeout deals, which may drive lumpiness and volatility in deal TCV in the coming quarters.

Earnings revision and valuation: Emkay Global expects IT companies to report growth moderation in Q3 on account of seasonal weakness and increasing caution among clients due to macro uncertainties. Client budgets, incremental commentary on the key vertical, deal pipeline composition, and pace of conversion will be keenly observed for assessing the near-term demand outlook. The hiring is expected to moderate due to the focus on improving utilization, deploying freshers post training, and possible demand moderation. Improved talent availability with significant fresher intake over the past few quarters and lower backfilling costs with reduced churn rate should aid in margin recovery. Rupee depreciated by 3% in Q3 against the USD; this along with less severe cross-currency impact in Q3 as compared to Q2 should aid in margin improvement.

Emkay Global has revised their earnings estimates for the coverage universe, factoring in revised forex assumption for H2FY23 (~Rs81.6/$), weaker consumer spending, and lower advertising/promotional spending. Nifty IT Index gained ~6% in the past 3 months, largely in line with broader markets.

Accenture’s results and management commentary have indicated demand moderation in the near term due to deterioration in macros, but management commented that medium-term growth drivers are intact, which should alleviate any structural growth concerns. Risks of recession and potential cut in FY24 revenue growth remain; however, increasing confidence on margin resilience and weak rupee would limit the earnings cut.

Emkay Global rolls forward the target price to December 2023 across their coverage universe. The pecking order is Wipro, Infosys, Tech Mahindra, HCL Tech, and TCS among Tier-1 players, and Zomato, Mphasis, Birlasoft, Firstsource, and Persistent among mid-caps.