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Q2 FY23 OVERVIEW

Maintaining TCVs and growth in a tough environment

We expect companies to largely maintain their TCVs and order intake for the quarter, suggesting resilience in a tough environment as clients continue to award contracts. Sector is likely to report aggregate $ growth of ~2% q/q and 14% y/y. On a sequential basis, $ growth has reverted to pre pandemic levels, despite cross currency headwinds of ~200bps in 2QFY23. We are not expecting any guidance revisions (CC basis) during 2Q.

Steep cross currency headwinds impacting reported $ growth

The biggest headwind (apart from rising employee costs) over the last two quarters has been cross currency. In 2Q, we are estimating ~200bps impact and the headwinds are continuing into 3Q because of the way average rates have moved. Therefore, higher US (or USD) exposure has become a tactical advantage for IT companies. Rupee depreciation will offer margin tailwinds.

Supple side begins to ease

Attrition for most companies has stabilized (flattish q/q) and given structural factors like lower expected growth in FY23 (versus FY22), lower utilisation (versus all time high in FY22) at companies, and higher fresher intake – all leading to expectations of lower supply side pressures in 2H. Given high levels of offshoring, rupee depreciation will also aid margins ahead.

STRUCTURAL CHANGES

Margin aspirations for midcaps have moved up by ~100bps, thereby reducing gap with large caps

At the aggregate level, we expect 2Q EBIT margins to be at 15.7%, ~100bps higher than pre pandemic levels compared to ~450bps at the peak, giving away ~80% of the during-pandemic gains in ~6 quarters. However, the performance is divergent at large caps versus midcaps during this time with midcaps improving margins and large caps seeing some erosion. Within midcaps, Mphasis is the only notable one not gaining on the margins.

Revenue productivity steady, utilisation dipped in Q1

Net headcount addition decelerated in Q1 FY23 after accelerating for 7 quarters (Q3FY22 being the only exception), in Q2FY23, we expect the net headcount addition to decrease further and normalise. On the other hand utilisation has been falling since Q2FY22, impacting the employee productivity to some extent.

Weaker rupee to help

Rupee was steady between Q4 FY20 and Q2 FY22 between Rs73 to Rs74. However, since Q3, it has depreciated steadily to reach Rs79.7 by Q2 FY23. In Q1, it depreciated 3% and in Q2, another 2.4% on average basis. Currently, it is hovering at Rs81.6, representing another 2.4% for Q3 FY23 and ~9% on y/y basis. This is the second biggest driver of profits for Indian IT after pricing

THE CONTINUITY

No major change in segment and geographic distribution of Indian IT revenue

Modest rise in shares of BFSI and Retail while slight decline in shares of Tech and Energy/Utilities verticals. Slight increase in the share of US.

Diversification may not be an advantage, concentrated bets may show more profit resilience

Large-caps with greater geographic and segment diversification than mid-caps but within top 5 as well, higher US concentrations will reflect into profit resilience. Midcaps with high Europe / RoW exposures likely to face more headwinds with KPIT being an exception due to Auto sector tailwinds.

LOOKING AHEAD

TCVs likely to cushion short term fluctuations in client spending

Companies with higher TCVs are likely to absorb impact of client specific ramp downs relatively better. Some midcaps may face early furloughs (BFS) and weakness in Hi-Tech/Retail during 2Q although most of the weakness in the US corporates profits has been around retail vertical.

While this will impact growth for few in 2Q, it is unlikely to be significant and overall TCVs will help them absorb this over the course of the year.

Indian IT gaining global share, large FDI flowing into Indian software sector

India’s 8%+ global share in computer (IT) and other business services (ITES) in 2020 was a record high. Indian IT/ITES exports growing faster than most peers and India is practically the second-largest globally, next only to the US. While MNCs setting up captives (through rising FDI) may be a short-term negative for Indian IT, eventually the relation would turn symbiotic. Recent developments in eastern Europe are likely to further solidify India’s position in IT exports.

40% lower valuations for midcaps and 30% for large caps offer comfort

Current valuations for many companies are now close to pre pandemic levels while growth rates and margins remain little on the higher side. At the aggregate level, median FY24 PE is now at 18x on our estimates, compared to Nifty at 16x .

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