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IT Q1 Preview | Strong revenue growth likely, margin pressure seen with high attrition rates

Kotak expects Infosys to maintain full year revenue growth guidance at 12-14 percent in constant currency terms and the EBIT margin band at 21-23 percent.

June 30, 2022 / 04:23 PM IST
 
 
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Information technology (IT) companies will kick off the first-quarter earnings season in July amid expectations they will post strong revenue growth, offset by pressure on profit margins exerted by higher. wage costs. IT companies including Infosys and HCL Technologies are unlikely to change their full-year guidance despite concerns of a recession in the US and Europe, analysts said.

Major IT companies typically announce their earnings for the three months ended June in the first fortnight of July, with Infosys and Tata Consultancy Services leading the pack.

The earnings season follows a tumultuous quarter marked by worries over the Russia-Ukraine war, accelerating inflation and tightening of interest rates by global central banks to cool it, supply-chain disruptions, and tumbling financial markets.

IT stocks have fallen the most among sectors, with the Nifty IT index correcting 29 percent from its high in January. Higher valuations and rising fears of an economic slowdown, even recession, in the US and Europe, the biggest markets for IT companies, weighed on the sector.

On a sequential basis, IT companies are expected to post diverging results because of sequential factors although they are expected to report strong year-on-year growth, Kotak Institutional Equities said in a report.

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Infosys will lead the way with revenue growth of 4.5 percent on a sequential basis, followed by TCS at 3.6 percent, the securities firm said. Seasonal weakness will dampen growth at Tech Mahindra, Wipro, and HCL Technologies, which may report 2.4-2.8 percent constant currency growth in revenue quarter-on-quarter, it said.

Among mid-tier companies, Mphasis is expected to report a weak quarter because of a likely decline in Business Process Outsourcing (BPO business linked to mortgage origination and refinancing. L&T Infotech may report modest 3.1 percent growth due to lower pass-through revenue while Mindtree will lead the way.

Before this year's correction in the Nifty IT index, the sector had had a healthy run-up since the outbreak of the pandemic, benefiting from the increasing adoption of digital media by students and salaried individuals cooped up indoors because of lockdowns.

"As the probability of a recession in the US has increased, there are renewed concerns in some cases around a slowdown in discretionary IT spends and this, coupled with lofty valuations, has resulted in a downward adjustment in stock prices," Siddharth Mehta, founder, and investment chief at Bay Capital said.

Dhananjay Sinha, Managing Director, Head Strategist, and Economist - Equity Research at JM Financial Institutional Securities said the valuation of IT companies is now closer to fair value after the recent correction in their stock prices. Feedback from companies suggests that their revenue outlook is intact so far.

"There may be some downside due to an eventual recession. But it may be temporary as we see structural tailwinds for IT spending by US companies over the longer horizon. A potential recession or an economic slowdown could ease the wage cost pressure for Indian IT companies over time," he said.

Margin pressure

Tech companies have already been grappling with pressure on their operating profit margins exerted by rising employee costs in the face of growing attrition. Kotak said the margin pressure seems to have bottomed out.

"Companies are incurring high talent retention costs (retention bonus, out-of-cycle wage revision etc.). The challenge exists in India as well as onsite. This pressure will seep into margins; we forecast 70-400 bps YoY decline in EBIT margin across the coverage universe," Kotak said. EBIT is short for earnings before interest and tax.

On a sequential basis, the securities firm sees headwinds in the form of wage revision for Infosys, TCS and Tech Mahindra, an increase in travel costs across all companies and visa costs for many and a decline in utilization as companies crank up hiring of fresh graduates.

Optically, Kotak feels the rupee's depreciation against US dollar may seem positive, but cross-currency headwinds have ensured only a marginal tailwind in the quarter.

The US dollar appreciated 5 percent, 6.6 percent and 1.7 percent against the euro, British pound and the Australian dollar, respectively, while the rupee depreciated 4 percent against the US dollar.

"Earnings before interest and tax has bottomed out in our view and will improve for most in the subsequent quarters as most pressure points are already absorbed, while efficiencies in the form of a pyramid, subcontracting cost rationalization and utilization will kick in later. The recent wave of rupee depreciation could also help," said Kotak. the June and September quarters would represent the peak of margin pressure.

Guidance

Kotak expects Infosys to maintain full-year revenue growth guidance at 12-14 percent in constant currency terms and the EBIT margin band at 21-23 percent.

HCL Technologies is also likely to retain revenue growth and margin guidance of 12-14 percent and 18-20 percent, respectively while Wipro could guide for 2.5-4.5 percent revenue growth on a sequential basis (1-3 percent organic), Kotak said.

Key things to watch out for

Investors will closely follow new deal wins, companies' commentary on demand, attrition, and pricing.

Kotak expects companies to report robust new deal wins. On attrition, the firm said it is likely to be more than 20 percent across companies as they deal with a talent crunch in a buoyant demand environment.

Disclaimer: The views and investment tips of investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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