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Tier-II information technology (IT) firms may hog the limelight when December quarter (Q3FY22) results come out. These companies are set to outperform their larger peers, yet again.

This is despite Q3 being seasonally weak for the Indian IT industry due to furloughs in key markets US and Europe. As such, robust demand, strong deal wins and pipelines, and an uptick in digital transformation and cloud adoption continue to be key drivers of revenue growth.

“We expect constant currency (CC) revenue growth of 2.7-4.4% quarter-on-quarter (q-o-q) at tier-I IT. Tier-II IT is expected to post stronger q-o-q CC growth at 5.1-9.5%," analysts at Ambit Capital Pvt. Ltd said in a report on 4 January.

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Tier-II IT providers are able to post faster growth than larger companies due to factors including improving level playing field as shrinking deal size leads to improved execution and deal conversion, analysts say. As far as margin growth is concerned, sequentially, Ebit (earnings before interest and taxes) margin is likely to remain flat for large IT companies.

“The commentary of midcap IT services companies in the Q2FY22 call on margin expansion was much stronger than their larger peers. In Q3FY22, the consensus expects mid-cap IT Services companies’ margins to expand by 40-160 basis points (bps) on a sequential basis, barring a few, and for larger-cap companies consensus expects margin expansion to be modest," said Kumar Rakesh, senior automobile and technology analyst at BNP Paribas India. One basis point is 0.01%.

Analysts expect the depreciation in the rupee to offset the negative impact of cross-currency movements. However, wage hikes would mean Ebit margin would contract year-on-year for most IT companies.

Needless to say, since supply-side pressure has been a pain point for the sector, commentary on hiring and attrition is crucial for margin outlook. Recall that global IT firm Accenture’s attrition rate fell by 200bps sequentially to 17% in Q1FY22 (three months ended November) from a multi-year high of 19% in Q4FY21. Accenture’s earnings are often seen as an indicator for the performance of the Indian IT sector.

Another driver for margins would be price hikes. Accenture had indicated that it had taken price hikes; so, commentary on that by Indian peers is key.

Meanwhile, investors have rewarded the growth outperformance of midcap IT stocks generously, evident from the stellar run in these shares in the last one year. Stocks such as Larsen & Toubro Infotech Ltd (LTI), Mphasis Ltd and Persistent Systems Ltd have rallied as much as 80-200%. In comparison, the Nifty IT index is up 53% in the same span.

Understandably, their valuations are expensive. For instance, based on Kotak Institutional Equities’ FY23 earnings per share estimates, the LTI stock trades at a price-to-earnings (PE) multiple of around 47. This is far higher than PE multiples of shares of Tata Consultancy Services Ltd and Infosys Ltd, which are trading at 33 and 32, respectively.

Kotak’s analysts caution that valuations have run up for most mid-tier IT companies and do not offer any margin of safety. Simply put, earnings growth has to be solid for the punchy valuations of midcap IT stocks to sustain.

That said, Ambit’s analysts see limited consensus earnings per share upgrades for the sector given the already elevated expectations. “We believe demand positivity is already reflected in street expectations and valuations are expensive, with tier-1/tier-2 IT building around 10.8-13.9/16.3-22.7% USD revenue CAGR over FY21-31E," added the Ambit report. CAGR is compound annual growth rate

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