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Starting 2021 on a high note

IT sector (coverage universe) is set to post its strongest 3Q sequential growth of the past eight years, despite the seasonality factor and the volatile macro situation. Following a 6% QoQ growth (rebound) in revenue in 2Q, 3Q is expected to print 3.7% QoQ for the sector. The stage is set for a double-digit FY22. Key drivers are (1) accelerated cloud consumption and shift to cloud (migration and modernisation of workloads) triggered by the pandemic, (2) portfolio consolidation of vendors and applications by enterprise clients driven by cost optimisation and leading to multiple large re-badging deals, and (3) improving partner ecosystem/alliances and continuity in strong execution, despite operational displacement and re-alignment. Profitability in 3Q is expected to be flat (-30bps QoQ following +240bps QoQ in 2Q) with wage hikes (TCS, WPRO, PSYS while others over 4Q and 1Q) and large deal cost, impact offset by operating leverage and favourable cross currency.

Large deal momentum remains strong and deals TCV numbers for 3Q are expected to be robust for TCS (PBS-Deutsche, Prudential, Equinor), INFY (Daimler, Rolls Royce), Wipro (Metro AG, Fortum), LTI (Injazat), and Mindtree (Nordex). M&A intensity (volume terms) accelerated in 3Q with nine acquisitions. Deal wins in the cyclical ER&D segment (LTTS-Schindler & O&G sector deal, Tata Elxsi-Aesculap AG) also point towards recovery trajectory. Other positive demand indicators from Accenture’s recent update include continuity in strong deal bookings and outlook of acceleration in its 2H.

* Revenue outperformance led by INFY, PSYS, LTTS, LTI: In 3QFY21E, we expect TCS/INFY/HCLT/WPRO/TECHM to post QoQ CC organic growth of +2.7%, +3.5%, +2.8%, 2.6% and +1.8% respectively. Within mid-tiers, QoQ growth to be lead by PSYS (growth in TSU+Alliance & Capiot acq.), LTI and LTTS (incl. Orchestra acq.) at 6.4% QoQ, 6.2% QoQ and 5.4% QoQ respectively. Within tier-1s TECHM is expected to lag growth and from mid-tiers ZENT is expected to lag. In terms of profitability, we expect tier-1 margins to decline by 29bps QoQ and mid-tier margin to decline by 50bps QoQ; LTTS & PSYS expected to outperform operationally as well.

* Key monitorables: (1) Commentary on client tech budget for CY21; (2) Progression/regression on large deals, overall deal bookings and deal pipeline; (3) Performance breadth by verticals and outlook on core verticals – BFSI, Retail & CPG; (4) Trends in large deals (closure timelines, profitability) and pricing trends in digital; (5) ER&D services outlook by industries; (6) DSO as temporary discounts reverse & capital allocation stance (increased volume of M&A activity in 3Q).

* Maintain constructive stance: We revise EPS est. higher by 1.0/2.5/4.5% for FY21/22/23E and raise TPs by ~10% on better growth/visibility (EPS CAGR for tier-1 at 15% and mid-tier at 19% over FY21-23E). Remain constructive on the sector despite valuations at >2SD with +20/50% performance of IT index in 3M/6M and 19/35% outperformance over NIFTY over 6M/12M. Our positive stance is premised on the longevity of high-growth (and strong BS) supported by multi-year industry tailwind from shift to cloud, increasing competitive advantage leading to continued market-share gains. Key risks are macro recovery upending and unfavourable USD-INR swing. We roll-forward valuations to Dec-22E, and our preferred picks include Infosys, HCL Tech, Mphasis and Persistent.

Exchanges and Staffing

* Within exchanges, MCX is expected to post a 15.6% QoQ decline in revenue due to 17.5% QoQ decline in ADTV, led by moderation in bullion volume and seasonality. Margins will contract 598bps QoQ to 48.3% due to non-linearity. Increase in volatility in global commodities, recovery in volume (metal & crude) and launch of index derivative contracts are positives.

* BSE witnessed weakness in its core business performance (cash volume down 6.4% QoQ) and cash market share slipped further down to 5.6% (down 30bps QoQ). BSE is gaining market share in the derivative segment where NSE is a dominant player, market share increased to 6.6% vs. 3.8% QoQ. The net cash (excluding SGF and clearing cash) is ~63% of market cap and value of CDSL stake after 25% discount is Rs 184/share. We maintain BUY with a target price of Rs 705, based on 10x core Dec-22 PAT + net cash + CDSL stake.

* CDSL will continue its strong performance in 3Q with +3.7/71% QoQ/YoY growth. Transaction revenue which doubled in 1HFY21 will witness some moderation in 3Q offset by pledge revenue. The recent SEBI directive (effective Oct-20) related to margin requirement has led to higher pledge creation. Online e-KYC approval and market traction is boosting online data charges. E-Voting and e-AGM revenue will continue in 3Q due to extended time line. The EBITDA margin will expand by 16bps QoQ to 61.1% and PAT will be increase 5.5 % QoQ to Rs 0.51bn.

* Within staffing, Teamlease will post a strong quarter with 12.2% QoQ growth in revenue, led by a recovery in core staffing (+13.4% QoQ). The strong recovery is led by festive season and gradual opening up of the economy. The EBITDA margin will improve by 21bps QoQ to 2.2%, based on continuous cost-cutting, improving business mix (high-margin specialised staffing) and higher core-associate ratio.

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