IT Q3 preview: Large deal wins to drive earnings but margins may take a hit

In a departure from past trend, Indian IT companies may post a strong performance for the third quarter of the financial year 2021 (Q3FY21) on account of healthy order pipeline, large deal signings and going by strong earnings from Accenture, believe analysts. Further, improvement in demand post Covid-19, acceleration in adoption of public cloud model, lower furloughs and decent growth in sectors such as consumer, technology and healthcare are likely to add to the revenues of the IT companies, they say.

Usually, December quarter is considered to be a seasonally weak quarter for IT companies due to lower working days.

However, analysts at Motilal Oswal Financial Services (MOFSL) believe that absence of headwinds like a repeat of the Covid-19-led lockdown or uncertainty with regard to the outcome of US Presidential election should drive the outperformance for IT firms in the quarter under review versus management guidance in Q2FY21. "Multiple mega deal wins in the cloud and captive segment should add incremental growth to an already buoyant organic growth momentum," the brokerage added in a sector preview report.

At the bourses, IT companies posted stellar performance for the three months ending December 31 with sector majors such as TCS, Infosys, Wipro, HCL Tech and Tech Mahindra rising between 15-24 per cent on the NSE. In comparison, the Nifty IT index jumped 21.55 per cent during the period, while the benchmark Nifty rose 24.30 per cent, ACE Equity data show.

Despite lofty valuations, MOFSL remains positive on the sector and believes a strong QoQ growth in a seasonally weak quarter should help sustain the rally in IT stocks despite their premium valuations.  

Revenue growth forecasts
 

Brokerages expect large-cap IT firms to report revenue growth in the range of 2-3 per cent in constant currency (cc) terms. This, coupled with cross-currency tailwind of 50-60 bps will further positively impact dollar revenue growth which is seen in the range of 3-4 per cent.

"We expect Infosys, TCS and HCL Tech to report strong revenue growth among large-caps with dollar revenue growth of above 3 per cent quarter-on-quarter (QoQ). Tech Mahindra will see constant currency revenue growth on the lower side at 2 per cent quarter-on-quarter (QoQ)," Vikas Ahuja and Ashish Agarwal, research analysts at Antique Stock Broking said in a note. They expect HCL Tech and Infosys to increase guidance marginally on strong Q3 results.

MOFSL, meanwhile, expects Infosys, TCS, and HCL Tech to see 4 per cent, 3 per cent, and 3 per cent QoQ growth, respectively in dollar revenue terms. "Accenture's recent earnings showed a strong increase in its outsourcing vertical, indicating recovery in demand. Coupled with strong deal wins across the IT sector, we expect an increase in guidance," the brokerage added.

As for mid-cap IT firms, analysts at ICICI Direct said that L&T Infotech (LTI) is expected to see a sharp rise in dollar revenues of 5.5 per cent QoQ followed by Mindtree, which is expected to witness revenue growth of 3.8 per cent QoQ. Similarly, Antique Stock Broking expects all mid-caps in its coverage universe, which includes L&T Infotech, and Mindtree among others, to report above 3.5 per cent cc revenue growth barring Cyient and Coforge.

"We expect Persistent and L&T Technology Services to report strong cc growth of 5 per cent and 4.6 per cent QoQ while Cyient is expected to grow at 3 QoQ," it added.

Impact on margins
 

On the downside, analysts foresee margins of the companies taking a knock during the recently concluded quarter on account of high base in Q2FY21 and resumption of wage hikes but believe that increasing digital mix, higher returns from utilization and positive operating leverage should offset a large part of the impact. Cross currency tailwinds should also offset the impact from rupee appreciation on margins, they added.

"Infosys and Wipro are expected to register 2-18 bps improvement in EBIT margins due to lower travel cost, rationalisation and operational efficiencies, partially offset by rupee appreciation. However, TCS & HCL Tech are expected to witness margin decline of nearly 100 bps mainly led by wage hikes," ICICI Direct said in a note. The brokerage further said that midcap companies are expected to report 3-45 bps improvement in EBITDA margins, with Mindtree leading margin growth with 45 bps.

Meanwhile, analysts at MOFSL said: "Sequential EBIT margins of Tier I players should be stable in the range of -60 to 40 bps, but the Tier II universe should see a 0-160 bps contraction due to wage hikes." A higher negative impact is expected in the next quarter when more companies would see an impact from a wage hike, the brokerage added.  

Key things to watch out for
 

During the quarter, many large-cap IT companies like TCS, Infosys and Wipro won large deals. Analysts at ICICI Direct believe that margins in these deals will be of key investor interest. In addition, with Brexit and many companies' focus on Europe, commentary in this geography will be a key thing to watch out for, they said. "Digital revenue growth, deal pipeline, vertical-specific commentary, offshoring, margin trajectory, guidance revision and long-term IT trends are important from an investor's perspective," they added further.

Besides this, Ambit Capital suggests watching out for the performance in retail, BFSI, telecom and manufacturing segments. "We believe there is a possibility of lagged pain in BFSI and retail uptick might not be sustainable as F500 financials weaken in CY21. However, we see more resilience in telecom and manufacturing sectors in FY22E".

Lastly, analysts at Nirmal Bang Securities in a note said that many IT companies have hinted at double-digit revenue growth in FY22 and given Accenture's FY21 guidance, double-digit growth in FY22 is quite realistic.  The Street, however, will try to assess the extent of strength and its longevity in the analyst calls, it added.