Indian information technology (IT) services companies, which kick off the corporate earnings season on April 11, are expected to report robust revenue growth for the fiscal fourth quarter but supply-side and cost pressures may hurt their profit margins, analysts say.
Tata Consultancy Services Ltd (TCS), India’s largest IT services company, will be the first to report its financial results for the three months ended March 31, followed by its closest rival Infosys Ltd on April 13.
Despite a high comparison base in the year-ago period, IT firms are expected to report robust revenue growth, with mid-cap companies expected to outperform their larger rivals, analysts tracking the sector say.
Supply-side pressure around employee attrition and cost pressure stemming from factors such as pay hikes for staff posted offshore and resumption of business travel may hurt margins, they said.
Performance of the sector
The IT services sector delivered a stellar performance during the first three quarters of the fiscal year, a fact borne out by the Nifty IT index (+50 percent) outpacing the benchmark Nifty 50 (+23 percent) in the last calendar year.
"We continue to remain optimistic on the Indian IT space, with strong fundamentals,” a report by the Singapore-based securities firm PhillipCapital said.
It expects Indian IT companies to continue to gain market share, especially in Europe, in the absence of global, diversified and quality IT vendors.
That’s in keeping with a decade-old trend. Technological research firm Gartner Inc noted that the global IT services market expanded at a compound annual growth rate (CAGR) of 3.2 percent in the past decade, compared with the 9.7 percent growth posted by Indian IT service exports, going by an estimate by the National Association of Software and Service Companies (NASSCOM).
Over the next five years, Gartner expects global IT services spending to expand at a CAGR of 9 percent, and if Indian IT companies maintain the same performance gap, mid-teen growth is a given for the industry.
Other factors that favour the Indian IT sector are deal wins and deal pipelines that are at record highs, and pricing power, especially for niche skills.
The coronavirus disease pandemic has made European clients realise the value proposition Indian IT services companies provide in terms of a business continuity plan, teh ability to migrate to new platforms, and high service standards that are opening up new opportunities in the region. Supply-side pressures are expected to ease soon, analysts say.
Midcaps to outperform large caps
In the Indian IT services landscape, mid-cap stocks have outperformed large caps handsomely over the last 12 months.
“On an average, mid-cap stocks have appreciated 200 percent in last 12 months and by 341 percent in the past24 months, compared to large cap IT stocks, which have moved up by 91 percent and 120 percent respectively,” PhillipCapital said.
Midcaps benefit from their better ability to control discretionary spending in the form of small deals and have less of a legacy drag compared to large-cap rivals.
“We expect quarter-on-quarter constant currency (c/c) organic revenue growth of 2.5-3.0 percent for large-caps, and 4.5-8.1 percent for mid-caps,” Nomura Global Markets Research said in a report.
Kotak Institutional Equities forecast that Tech Mahindra Ltd and Wipro Ltd would deliver 2.6 percent and 3.1 percent organic c/c sequential revenue growth.
In a report, it said Infosys is expected to report muted quarter-on-quarter QoQ) growth of 2 percent in constant currency terms because of lower pass- through revenues.
“We expect TCS to grow at 2.4 percent QoQ, HCL Tech will report modest 0.6 percent growth (3 percent growth in services, decline of 15.4 percent in products) while acquisition contribution of 2.5 percent will boost Tech Mahindra’s c/c revenue growth to 5.1 percent,”the Kotak report added.
“Mid-tier companies will report better results with growth rates ranging from 4-5.5 percent on c/c basis on quarter”.
Margins under pressure
Indian IT companies have battled supply-side headwinds for the past few quarters with employee attrition at record levels amid a paucity of skilled workers. The increase in global demand for IT services has led to an unprecedented software talent crunch in India, prompting exceptional salary hikes and a drop in margins for companies.
“We forecast EBIT (earnings before interest and tax) margin decline of 170-350 bps on YoY comparison for Tier-1 IT companies,” Kotak Institutional Equities said in a report. Bps is short for basis points; one basis point is one-hundredth of a percentage point.
On a sequential basis, it expects an EBIT margin decline of 10- 70 bps due to higher wage costs and lower utilization rates.
Nomura expects EBIT margins to decline by ~0-50 bps on quarter for large caps (least for TCS and HCL Technologies Ltd at ~0 percent) and the highest for Tech Mahindra at ~55 bps.
“In mid-caps, we expect a decline of ~20-50 bps (excluding Mphasis), with the highest decline for L&T InfoTech Ltd.”
Continued supply-side challenges around high attrition, higher-than-usual hikes for offshore employees and some resumption of discretionary spending like that on travel would weigh on margins in the quarter ended March 31.
Outlook
Analysts tracking the sector remain positive on the demand outlook and expect healthy revenue growth to continue. Companies are likely to sustain growth momentum on broad-based demand and a robust deal pipeline.
“IT companies are seeing a conducive environment for price increases; however, near-term margins are expected to remain under pressure as pricing improvement is lagging the impact of salary inflation,” said a report by Emkay Research.
Companies have substantially increased the hiring of fresh graduates to expand the talent pool of skilled employees, which should hopefully address the shortage of skilled workers and reduce the cost of delivery.
“We believe headwinds like high inflation in developed markets forcing higher-than-usual salary hikes for onsite employees, resumption of travel and higher visa costs would only be partly negated by tailwinds like improved pricing and currency depreciation,” Nomura said.
On an overall basis, the Japanese securities house expects EBIT margins to decline by 80-125 bps for large caps and 40-130 bps for midcaps in fiscal year 2023 (excluding Persistent Systems). It expects Infosys to guide for a 12-14 percent on year revenue growth in constant currency terms, with a 22-24 percent EBIT margin for the year.
HCL Technologies is likely to quantify its “double-digit” revenue growth forecast to 10-12 percent, with an unchanged EBIT margin band of 19-21 percent.
PhillipCapital is betting on TCS and Infosys among large caps and on Mindtree Ltd, Coforge Ltd, Mphasis Ltd and KPIT Technologies Ltd in the midcap space.
Nomura prefers Infosys and Wipro among large caps and Persistent Systems among midcaps. It has downgraded TCS and Mphasis to ‘neutral’ from ‘buy’ earlier because of the limited upside it sees to its target prices.
Securities firms say that it would be important to monitor the impact of macro and geopolitical uncertainties on tech spending.
Other factors to watch will be demand trends in key segments such as banking, financial services and insurance; retail; manufacturing; and communications, growth and margin outlook in the new financial year , deal intake and pipeline in the fourth quarter; and the pricing environment given high inflation, supply-side challenges and attrition.
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