BackIT firms unlikely to sustain high margin as covid-led cost savings may fade
In Q2, IT companies reported sharp decline in attrition rates but as several companies have reinstated wage hikes and promotion cycles, employee costs are also expected to rise
PremiumMUMBAI : Even as most IT services companies reported better-than-expected September quarter earnings, analysts feel that the benefits of cost rationalisation measures in the pandemic may fade away over a period of time, thus impacting ability of these companies to sustain high margin growth.
According to Mint analysis of eighteen IT companies that have reported September quarter so far, net sales improved 4.33% year-on-year while adjusted net profit grew 7.63% (YoY) with net profit margin rising 17.08% (YoY) in Q2FY21. For the top five IT companies, net sales improved 4.31% (YoY), while adjusted net profit grew 7.68% in the July-September.
However, according to Kawaljeet Saluja and Sathishkumar S, analysts at Kotak Institutional Equities, only a small part of the earnings before interest and taxes (EBIT) margin expansion reported by most companies in Q2 is sustainable.
They believe that the September quarter margin represents a peak and will decline over the coming quarters.
“Benefits of many of the costs saved such as travel, facilities costs, lower selling and marketing and deferral of wage revisions will fade away over a period of time. Utilization rate can vary considerably and may not be a sustainable margin lever. Retention of some of the benefits will depend on the competitive environment and operational rigor," the analysts said. They expect 1-2% acceleration in growth for the Indian IT services sector over the next three years.
In Q2, IT companies reported sharp decline in attrition rates but as several companies have reinstated wage hikes and promotion cycles, employee costs are also expected to rise.
For instance, Infosys which saw the highest ever deal wins in the September quarter guided for a revenue growth for FY21 at 2–3% year-on-year constant currency indicating a modest second half of FY21.
“Also a 23–24% EBIT margin band cannot be considered sustainable for now; this will have to be keenly monitored. Notwithstanding the higher variable payouts, the company delivered robust margin expansion in the quarter. We believe some of the margin tailwinds are not sustainable, and their benefits would wane out partially as travel comes back and the attrition and offshore ratio normalizes," analysts at Motilal Oswal said.
Elevated valuations of some of these companies are also weighing on sentiment. Steep valuations of some IT stocks especially in the tier 2 companies may take shine away from the sector, feel analysts.
“Like largecap companies, most of mid-tier IT companies are currently trading higher than historical average multiples considering acceleration of growth over next few years. Note that some quality midcap companies are trading at par with TCS given elevated growth trajectory, consistency in deal wins, strong balance sheet with superior return ratios, healthy free cash flow generation and higher payout ratio. We have positive stance on the sector," Sanjeev Hota, head of research, Sharekhan by BNP Paribas said.
So far this year, BSE IT index gained nearly 35% against a decline of 4% of benchmark Sensex. Midcap IT companies such as Mastek, Mindtree, Mphasis have jumped 47-140% while TCS, Infosys and Wipro share rallied 21-45% in 2020 so far. TCS trades at 30.47 multiple of one-year forward price to earnings, Infosys at 24.19 times, while smaller firms like L&T Tech, Mindtree and Mphasis are at 20-26 times, as per Bloomberg data.
Devang Mehta, Head, Equity Advisory, Centrum Wealth Management, however, feels that despite the elevated valuations, markets are willing to give them a thumbs up on premium valuations as they are delivering growth.
“Visibility in terms of revenues, margins and profitability look good for the next two to three years," he said.
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