Beating high expectations critical for further gains in midcap IT stocks

While the overall growth outlook is positive, there are headwinds for margins and valuations are at premium to large-cap IT firms

Strong demand, especially in North America, should mean good results for the information technology (IT) sector. However, continuing margin pressures and higher employee-related expenses will stem the rate of attrition. Indian IT services companies will rely upon rupee depreciation and higher efficiencies to maintain margins, while looking at continuing migration to Cloud to drive revenue growth.

Various analysts are expecting constant dollar sequential revenue expansions of between 3 per cent and 8 per cent in the third quarter (Q3) of 2021-22 (FY22) for mid-caps in the IT space.

Revenue growth is likely to be broad-based across geographies and verticals. There could be year-on-year (YoY) margin declines, given that companies have been forced to give wage hikes. The large-caps may all be looking at acquisitions to boost their digital competencies – this could mean significant inorganic revenue growth.  

This positive outlook is regardless of seasonal weakness, with fewer working days due to the holiday season. Investors will be watching for momentum around deal wins and guidance on likely client technology budget expansions for the next financial year.

Accenture’s guidance of 21 per cent YoY dollar revenue growth in its outsourcing services business is being seen as a positive sign. The work-from-home status due to increasing Covid cases will, however, be watched with some concern as well.

In the longer term, while large-cap IT companies’ growth could be double-digit compound annual growth rate (CAGR) for three years, mid-caps should grow faster, maybe hitting 18 per cent CAGR. However, mid-caps are generally trading at high valuations, which mean there’s more scope for disappointment.

On the whole, the Nifty IT Index is trading at roughly 45 per cent premium to the Nifty in terms of forward earnings – this is higher than the historical premium. Mid-caps are trading at elevated valuations, compared to large-caps. Many of the mid-caps are at 50-plus price-to-earnings (expected FY22 earnings per share), whereas Infosys and Tata Consultancy Services (TCS) are at around 35x.

Among mid-caps, Persistent Systems and Larsen & Toubro Infotech are expected to report strong numbers, with sequential revenue growth of above 8 per cent in Q3FY22.

Mindtree and Coforge are expected to report growth of above 6 per cent.

Cyient and L&T Technology Services (LTTS) are expected to grow at 5 per cent. LTTS and Coforge are expected to see the highest earnings growth.

These could be taken as rule-of-thumb Street expectations. Beating these expectations could be critical for upsides in share prices.

Cyient, Coforge, and Mindtree have higher exposures in the travel vertical, which could have a weak forward outlook, given the resurgence of soft lockdowns.

Obviously the guidance of major IT companies, which are to declare results in the next two days, will lead to some modification in sentiment and estimates for mid-caps.

TCS, Infosys, and Wipro are expected to show strong Q3 performance and the Street is expecting upgrades to the revenue and earnings guidance. If this does happen, the outlook on mid-caps will also be more optimistic.

The Nifty IT Index has outperformed the Nifty between October 1, 2021, and December 31, 2021, with a rise of 10.5 per cent versus a fall of 1.5 per cent, respectively. In the last year, the IT Index had returned over 51 per cent, while the Nifty had returned 27 per cent. This outperformance is expected to continue.