Growth momentum to continue

Sonata posted better-than-expected growth in the IT services (IITS) and Domestic Product Services (DPS) segment. IITS revenue grew 5.1% QoQ (estimate +4%) and margin expanded 428bps QoQ to 27.9% (8 quarter high). The growth in IITS was led by a revival in ISV (+14.8% QoQ) and Retail (+13.7% QoQ). Travel also recovered (TUI was stable) but more clarity will emerge in April-21 (leisure travel is expected to resume). The Microsoft portfolio (~48% of IITS revenue) registered a strong growth of 7.1% QoQ, led by ISV and Dynamic 365.

The Microsoft Dynamics modernisation program is a multi-year opportunity (~10K enterprises yet to upgrade) and Sonata is investing in R&D and sales capabilities to capture this opportunity. The IITS EBITDA margin expansion was led by offshoring and higher utilisation, the target range being ~23-24%. DPS growth was impressive (+20% YoY) and is driven by higher cloud adoption (~63% of DPS is cloud).

We like Sonata’s IPled business model, the high margin in IITS, focus on high growth Microsoft ecosystem, healthy RoE (~35%), and high dividend yield (~4%). We increase our EPS estimate by +6.0/7.5% for FY22/23E to factor in growth acceleration. Our target price of Rs 460 is based on 14x Dec-22E EPS. Maintain BUY. The stock trades at a P/E of 16.9/14.0x FY21/22E.

* 3QFY21 highlights: IITS revenue stood at USD 41mn (+4.5% QoQ CC) vs. an estimate of USD 40.6mn. Digital/IP-led/Platform revenue contributed 64/33/18% to IITS revenue and grew 12/5/5% QoQ. Utilisation at 89% (+200bps QoQ) and Offshoring (+300bps QoQ) led to IITS margin expansion. Consolidated revenue was up 73.7% QoQ due to DPS (+110% QoQ) and EBITDA margin stood at 7.9% vs. an estimate of 8.5%, due to the lower margin in DPS (-126bps QoQ). The salary hike will be effective Jan-21. Net cash is at INR 6bn (14% of mcap). The company partially settled the contingent liability on its balance sheet by INR 500mn by paying a tax of INR 218mn under the special tax settlement scheme.

* Outlook: We expect IITS growth of -12.1/+13.4/+11.6% and DPS growth of +22.9/+18.2/+18.3% for FY21/22/23E. IITS margin will be at 24.2/23.2/23.6% and DPS margin at 2.8/2.8/2.9% for FY21/22/23E respectively. Revenue/EPS CAGR for FY21-23E is expected at +17/+19%.

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