Q2FY19 preview: IT firms to report higher sequential EBIT margin on Re fall

We expect the IT firms under our coverage universe to post a combined 1.5 per cent QoQ growth in US dollar revenue in 2QFY19. Reported US dollar revenue is likely to be adversely affected owing to the strengthening of the US dollar against major currencies including euro, GBP (British pound) and Australian dollar (2-4 per cent QoQ appreciation on quarterly average rate).

We expect 50-130 bps adverse impact of cross-currencies in 2QFY19E. The top five IT firms are likely to post 1 per cent to +2 per cent QoQ growth in US dollar revenue (0.5 per cent - 3.3 per cent QoQ in CC terms), with TCS likely to lead the pack (2 per cent QoQ US dollar growth, 3.3 per cent in CC terms).

Mid-sized firms are expected to see good growth with Cyient likely to lead the pack (3.6 per cent QoQ US dollar growth, 4.7 per cent in CC terms), followed by KPIT Technologies (2.8 per cent QoQ US dollar growth, 3.6 per cent in CC terms) and Mindtree (2.7 per cent QoQ US dollar growth, 3.5 per cent in CC terms), while Persistent Systems (1.6 per cent QoQ US dollar growth, 1.9 per cent in CC terms) will underperform owing to unfavourable QoQ comparison. In rupee terms, revenue growth is likely to come in at 0-8 per cent QoQ owing to rupee depreciation of 4.5 per cent QoQ.

On the margin front, we expect a largely upward trend aided by revenue growth, rupee depreciation, wage hike impact, largely behind and operational efficiency. Among top-tier firms, we expect Tech Mahindra (TechM) to post 106 bps QoQ margin expansion, aided by currency and operational efficiency. We expect TCS and Infosys to report margin expansion of 62 bps and 72 bps QoQ, respectively, while we forecast 47 bps QoQ margin rise for HCL Technologies (HCLT). Within our mid-cap coverage universe, we expect Cyient (+184 bps QoQ) and Hexaware Technologies (+129 bps QoQ) to report the strongest margin growth. On the other hand, KPIT Technologies is likely to post 60 bps QoQ decline in margin owing to a wage hike. On YoY basis, margin performance is likely to improve with 10 out of 14 companies under our IT coverage universe likely to post expansion of 30-470 bps (excluding Majesco).

We would watch for FY19 growth outlook/guidance, digital growth, increasing digital deal sizes, the digital proportion in context of Accenture’s impressive growth, sustainable margin outlook, deal flows and the outlook for key verticals including BFSI, Retail and Telecommunications. 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 in the past year to make better use of their cash balances.

CC revenue growth likely to be healthy, led by digital

We expect 0.5 per cent - 4.7per cent QoQ CC revenue growth for IT firms under our coverage universe in 2QFY19E. On the other hand, US dollar revenue is likely to grow by 0.6 per cent to +3.6cper cent QoQ with an adverse cross-currency impact of 50-130 bps likely. We expect healthy growth in digital revenue to drive overall growth. YoY US dollar revenue growth is likely to come in at 6.7per cent at an aggregate level. Individually, just 5 out of 14 stocks under our coverage universe will report double-digit YoY growth on adverse cross-currency. Company-wise, TCS will lead growth among top-tier IT firms, while Cyient is expected to lead the mid-tier firms.

Margins to trend higher on rupee weakness

We expect IT firms to report largely higher sequential EBIT margin in 2QFY19E aided by rupee depreciation, operational efficiency, wage hike largely behind and revenue growth. Among top-tier IT firms, TechM’s margin is expected to expand by 106 bps QoQ aided by favourable currency movement and improved operational efficiency. Within our mid-cap universe, Cyient is expected to report the strongest margin performance (+184bps QoQ).

Focus on digital & outlook on key verticals

In our view, key monitorable for the Street from the second quarter results are likely to be digital growth, digital deal size trend and the outlook for key verticals including BFSI, Retail and Telecommunications. Apart from this, improving FY19E outlook and order book are critical data points to watch out for.

Our Top Picks: HCLT among the large caps, Sonata Software among the midcaps

Harit Shah is Research Analyst (IT) at Reliance Securities.