Midcap IT firms to beat large peers, but margin contraction risk is high
Robust demand in a seasonally strong quarter is likely to yield good earnings for Indian IT firms. Deal wins and pipelines are poised to see healthy growth in Q2FY22Shares of tier-2 firms Mindtree and LLTS have risen nearly 200% in the past one year
IT firms would once again emerge as star performers in the upcoming results season. Robust demand in a seasonally strong quarter is expected to translate into blockbuster earnings for Indian IT firms. Deal wins and pipelines are poised to see healthy growth in Q2FY22. This will be backed by steady deal closures and an uptick in digital transformation and cloud adoption.
Akin to the trend seen in Q1, this time as well, tier-2 IT firms are likely to beat tier-1 peers in terms of revenue growth. “We expect median growth of 5.4% constant currency (CC) quarter-on-quarter (q-o-q) in Q2 in our IT services coverage universe. Tier-2 IT should continue to outpace tier-1 IT in terms of growth," analysts at Motilal Oswal Financial Services Ltd (MOFSL) said in a report.
The domestic brokerage house foresees tier-1 firms delivering revenue growth between 3.9% and 6.9% q-o-q CC, while tier-2 firms will have a wider growth band of 4.9% to 10.5% q-o-q CC, it said. This optimistic growth outlook has also rubbed off on stock performances with midcap IT stocks impressively beating their larger peers in the recent past. For instance, shares of tier-2 firms Mindtree Ltd and LLTS have risen nearly 200% in the past one year. In the same period, TCS Ltd and Infosys Ltd have given relatively modest returns of 40-60%.
The valuation multiple of the IT sector is at a steep premium to its historical average. Furthermore, midcaps are trading at much higher valuations than large caps. However, margin pressure could elevate and come as a damper to this relentless rally in IT stocks as well as put expensive valuations at test.
Currently, there is high demand for tech talent, which has led to a supply-side crunch. “While skill-specific cost has increased in the market, we expect companies to try to right size their pyramids in order to offset the increase. Hiring across our IT coverage will continue to remain high as companies try to fulfil demand and backfill growing attrition, which will be a key focus area for investors. Tier-1 IT companies are better placed to absorb supply pressures, given their capabilities with regard to training employees in newer skills," analysts at MOFSL said in a report.
Salary hikes, higher subcontracting costs, rise in attrition and higher recruitment expenses are some other factors that could weigh on margins.
“Companies have rolled out wage increases twice since the December 2020 quarter, which shows a year-on-year decline in margin. Margin picture will be weak on a sequential basis as well with primary headwinds emanating from backfilling of attrition with lateral recruitment," analysts at Kotak Institutional Equities Ltd said in a report on 4 October.
“Lateral recruitment costs 25-30% more, decline in utilization rate as companies load up on fresher hiring and creep up in discretionary costs. Pricing leverage is not enough to offset some of these headwinds," added the Kotak report.
In this context, management commentary on measures taken to address supply-side challenges and available levers to protect margins will be key for investors. Besides, trends in attrition, outlook on pricing and deal win momentum would be closely watched.
So, analysts at Ambit Capital Pvt. Ltd see limited likelihood of earnings upgrades in tier-1 IT, which have been elusive since January at Infosys, TCS and HCL. “Some upgrades to growth are possible at tier-2 IT firms, especially Mindtree, where traction is better, but margin pressure could counter material earnings per share upgrades," said the Ambit report.
Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!