Q3 preview: IT firms likely to post muted numbers; some mid-caps may shine

For Tier-I companies, most analysts see revenue growth between 1.3 per cent and 3.5 per cent in constant currency (CC) terms on a sequential basis.

Information technology (IT) companies' financial performance may have been muted in the October-December quarter (Q3) of the 2019-20 financial year, thanks to a seasonal weakness due to furloughs and fewer work days, besides continued challenges in the banking, financial services and insurance (BFSI) and retail verticals. Additionally, a waning impact of tax reforms in the US, and policy uncertainty ahead of Presidential elections there, might also have subdued the performance of Indian IT services companies.

The October-December period is usually a soft quarter for IT firms, since it has fewer work days due to the holiday season that falls in it. According to analysts, some IT vendors have cited a higher impact of furloughs in Q3 of FY20 than in the same quarter of last year. This might mean tepid revenue growth in Q3 this year.

For Tier-I or large-cap IT companies (TCS, Infosys, HCL Tech, Tech Mahindra, and Wipro), most analysts see revenue growth between 1.3 per cent and 3.5 per cent in constant currency (CC) terms on a sequential basis. The appreciation of the British Pound (GBP) against the US dollar could have added 20-35 basis points (bps) to CC growth, they say. The rupee's depreciation might have acted as a key margin tailwind.

DISAPPOINTMENT IN STORE

Factors like slower economic growth in the US, Europe and China and its impact on customer financials, concerns about a no-deal Brexit, and the German economic slowdown impacting the European BFSI and manufacturing sectors, are likely to bring disappointment on both revenue and margin fronts in H2FY20, wrote Nirmal Bang Securities head of research Girish Pai and research associate Seema Nayak in an earnings preview note.

Among other factors that could have weighed on the IT sector in Q3 are concerns over demand from the global BFSI sector amid negative yields across a large number of bonds, and a potential softening of prices -- both in digital and legacy services -- owing to suppressed customer spend and a growing supply of digital talent.

WHAT TO WATCH OUT FOR

Commentary on key verticals, deal wins and attrition rates will be some of the key monitorables in the quarter under review.

"Caution in spending within key verticals -- BFSI and retail -- has resulted in growth moderation for IT companies in the past two quarters. In that context, the investor focus will be on commentary around early budget trends in these verticals for the new calendar year. Deal wins and commentary around the pace of deal pipeline conversion will be other key monitorables on the demand side," said analysts at Motilal Oswal Financial Services (MOFSL). Further, attrition rates, along with commentary around onsite supply bottlenecks, will be key areas of investor focus.

Among individual names, HCL Tech is the top pick of most brokerages, besides Infosys and Tech Mahindra. For instance, Emkay Global Financial Services, which is negative on the IT space, has a 'buy' rating on the HCL Tech stock with a target price of Rs 675. Similarly, MOFSL has upgraded the stock to 'buy' with a target price of Rs 700 (up 22 per cent).

According to MOFSL, a repatriation of workloads from public cloud to on-premise/hybrid cloud is likely to be a key emerging horizontal theme for the IT industry, and HCL Tech is seen as the biggest beneficiary of that. "As clients rebalance workloads from public cloud to on-premise and eventually to hybrid cloud, we expect HCL Tech to emerge as a key beneficiary," it said.

In the mid-cap space, revenue growth is likely to have remained a challenge during the quarter due to the impact of furloughs. However, select names are expected to post healthy numbers. Most analysts are bullish on Larsen & Toubro Infotech (L&T Infotech), NIIT Tech, Hexaware, and Persistent Systems.

L&T Infotech (LTI) is expected to report the strongest growth (5.5 per cent QoQ), while Cyient could witness a steep decline of 5 per cent QoQ, said ICICI Securities. "Comfortable owning a basket of mid-cap IT stocks for now, though one needs to continuously evaluate the thesis, given an uncertain global macro, high client concentration of mid-sized vendors and willingness of larger companies to more aggressively engage with smaller clients, the brokerage added.

PERFORMANCE AT THE BOURSES

Thus far in the fiscal year 2019-20 (FY20), the Nifty IT index has gained around 2 per cent while the benchmark Nifty50 index has added over 5 per cent.