IT Q3 preview: Seasonally slow quarter; CY19 outlook to be watched

The top five IT firms are likely to post 0.7%-2.1% QoQ USD revenue growth (1.3%-2.6% QoQ in constant currency (CC terms) with Tech Mahindra (TechM) likely to lead the pack

We expect the IT firms under our coverage to post a combined 1.4 per cent quarter-on-quarter (QoQ) rise in revenue in US dollar terms in Q3FY19 - a seasonally weak quarter, owing to furloughs and lower billing days led by the holiday season. Reported USD revenue is likely to be adversely affected on US dollar strength against cross-currencies including Euro, British pound and Australian dollar (1.3-2 per cent QoQ appreciation on quarterly average rate).

We expect 50-70 basis points (bps) adverse impact of cross-currency movement for top-tier IT firms, while for mid-tier IT firms, impact is seen at 25-45bps (with the exception of Cyient, which is likely to see 66bps adverse impact on higher Euro, British pound and Australian dollar exposure of >35% on combined basis).

The top five IT firms are likely to post 0.7 per cent-2.1 per cent QoQ USD revenue growth (1.3 per cent-2.6 per cent QoQ in constant currency (CC terms) with Tech Mahindra (TechM) likely to lead the pack (2.1 per cent QoQ USD growth, 2.6 per cent CC growth). Among mid-sized firms, Persistent Systems (Persistent) should outperform with 6.6 per cent QoQ USD revenue growth led by IP business seasonality, while Cyient is likely to trail (flattish revenue owing to weak DLM seasonality). In rupee terms, revenue growth is likely to come in at 2-9 per cent QoQ owing to rupee depreciation to the tune of 2.9 per cent QoQ.

On margin front, we expect a flat-to-upward trend with rupee depreciation the key tailwind to offset lower revenue growth in a seasonally weak quarter. Among top-tier IT firms, we expect Wipro to post 200 bps EBIT margin expansion in its combined IT services business led by the absence of one-time items and rupee depreciation. Other top-tier firms are expected to post largely range-bound margins with some margin gains likely to be reinvested to sustain revenue growth, going forward. Within our mid-cap coverage universe, we expect Persistent (+105bps QoQ) to report the strongest margin performance aided by an uptick in IP business and rupee depreciation.

We would watch out for CY19 IT budget outlook, outliers for FY20E revenue growth in the form of BFSI and Retail growth and outlook, apart from telecommunications vertical outlook, digital growth and deal sizes in context of Accenture’s impressive growth, apart from deal flows. Return of cash to shareholders is a theme that continues to play out with TCS, Infosys, Wipro, HCLT, Hexaware, Mindtree and eClerx all resorting to share buybacks to make better usage of their cash balances.

Seasonally weak quarter, outlook more important to gauge FY20E

We expect 1-7 per cent QoQ CC revenue growth for IT firms under our coverage universe in 3QFY19E. USD revenue is likely to grow at 0-6.6 per cent QoQ, with a likely adverse cross-currency impact of 25-70 bps. Digital revenue should continue to drive growth. USD revenue growth on year-on-year (YoY) basis is likely to come in at 7.6 per cent at an aggregate level. Individually, just four of the 14 stocks under our coverage will report double-digit YoY growth on adverse cross-currency movement. TCS will lead growth among top-tier IT firms, while Mindtree should lead mid-tier players.

Our top picks in the sector are: Tech Mahindra among the large-caps, Sonata Software among the mid-caps.

The author is a Research Analyst at Reliance Securities. Views expressed are his own.