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Good for now; Margin commentary needs watching

Sequential revenue growth across the sector is likely to moderate in 4QFY22 (2.7-5.3%QoQ c/c revenue growth) with TechM and Wipro leading amongst Tier I techs.Tier II techs will outperform Tier I techs on growth yet again. EBIT margins will be down by 110-340 bps on a YoY basis across Tier I techs. While demand remains robust, we reckon downside risks to margins (current consensus expectations of ‘flat to higher’ margins in FY23 on a YoY basis, refer exhibit 7 below) given elongated supply side pressures and likely resumption of travel/facility expenses in FY23. This is likely to drive both INFO and HCLT to mark down the margin band for FY23. We see atleast a pause (and potential cuts to EPS estimates after a revenue/EPS upgrade cycle that the sector has enjoyed through the past 18-21 months!) driven by margin reset even as underlying demand/pricing trends remain supportive. HCLT, INFO and TECHM are our preferred picks amongst Tier I techs. PSYS and MPHL amongst the Tier II techs

Steady sequential revenue growth performance likely: Tier I techs are likely to report a 2.7-5.3% QoQ revenue growth with TechM(including the 220 bps inorganic benefit) leading the charge and HCLT at the lower end due to the weak seasonality of the P&P business. Tier II techs are likely to see strong revenue growth as well with a 3.6-6.9% QoQ c/c growth with PSYS and MTCL leading on growth within the pack. Cross currency headwinds will pull down the sequential growth for the 3rd successive quarter by 40-100 bps across Tier I techs

Margins performance/outlook to be the key montiorable: EBIT margins are expected to decline on a YoY basis across all Tier I techs(-110-340 bps YoY change). Margin performance and outlook will be keenly watched given potential resumption of certain costs and elongated wage pressures going forward. We note that while the companies have continued to step up fresher hiring in addition to enjoying the benefits of growth and pricing strength (likely to be supportive into FY23 as well!), the elongated supply side pressures and resumption in travel expenses will pose pressure on margins in the near term. Street wide expectations of ‘flat to improvement in margins’ in FY23 is likely to be tested in the upcoming earnings season.

INFO may guide for 12-14% YoY c/c growth; both INFO and HCLT may mark down margin band: We expect Infosys to guide for 12-14% YoY c/c revenue growth for FY23 (starting the year with a similar range as FY22) and implying a 1.8-2.5% CQGR through the course of the year. We expect HCLT to guide for double digit revenue growth as well. We expect both INFO and HCLT to take down their margin band to reflect the likely resumption in travel/facility expenses in addition to elongated supply side pressures. We expect INFO to guide for 21-23% EBIT margin band(V/s 22-24% earlier) . Similarly, HCLT may also guide for 100 bps dilution in the margin band to 18-20% for FY23(V/s 19-21% earlier, note that FY22 EBIT margins likely to end closer to the lower end!)

Demand remains robust; margin reset to drive near term risks to earnings estimates: While the demand environment remains strong as highlighted in our recent notes (IT Services: The Global Lens dated Feb 22nd’2022 and IT Services: BFS growing ahead of company once again dated Mar 9th’2022), we see a pause at the least (with possibility of near term downgrades to consensus EPS estimates) driven by downside risks to margins due to elongated supply side pressures and likely resumption of travel/facility expenses even as the sector continues to enjoy both volume and pricing leverage. HCLT, INFO and TECHM are our top picks amongst the Tier I techs. PSYS and MPHL are BUY’s amongst the Tier II universe

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