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Q3 FY23 OVERVIEW

Slower growth, steady margins

We expect companies to largely maintain their TCVs, but report slower growth in Q3 for various reasons such as more furloughs or client-specific challenges.

The sector is likely to report aggregate ~2% q/q dollar growth and 8% y/y on $ basis (~13% CC). Sequentially, dollar growth has returned to pre-pandemic levels.

Margins are likely to inch up sequentially on many tailwinds (lower cross-currency headwinds, easing attrition pressure and rupee depreciation). More benefits are likely to follow in Q4.

Outliers on the upside are HCLT, Coforge, Persistent, KPIT and Latent View.

Outliers on the downside are Mphasis and FSL.

STRUCTURAL CHANGES

Mid-size IT continues to outgrow larger peers, but the gap narrowed in Q3

Mid-size IT companies (PSYS, Mphasis, Coforge, LTIM and LTTS) continue to grow faster over longer periods. However, Q3 may see a few of them navigating specific challenges, leading to a narrowing of the growth gap with larger peers.

Client quality is critical in economic slowdowns to avoid sudden ramp-downs. Expect growth divergence ahead.

Revenue productivity steady, utilisation improved in Q2

Net headcount addition slowed in Q2 FY23, a second consecutive quarter of deceleration. In Q3 FY23, we expect net headcount addition to further decelerate and normalise. On the other hand, utilisation improved in Q2 after having fallen for four straight quarters, leading to steady employee productivity to some extent

Niche small players retain high growth rates

Smaller but niche companies such as KPIT, Latent View and Happiest Minds continue to maintain high growth rates.

Weaker rupee, lower attrition to help

The rupee depreciated ~3% in Q3 FY23 and is likely to offer margin tailwinds. So is the case with attrition, which impacted smaller IT companies more than the large ones over the last year. As it comes off, talent replacement cost will be lower and smaller companies will benefit more on the margin front.

THE CONTINUITY

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

Modest rises in shares of Retail and Manufacturing while a slight decline in the share of the Tech vertical.

Slight increase in the share of the US while a small decline in Europe and APAC contributions.

High US exposure has benefited companies in the last six months, companies with high Europe exposure to benefit in Q4

Exceptions: Mphasis and Birlasoft have undershot despite having high US exposure on account of company-specific challenges. KPIT, Coforge and Sonata have outperformed despite high Europe exposure.

Companies with high exposure to Europe to benefit from the tailwinds from the euro/dollar movement in Q4. Within the top-5, TCS and Wipro have higher exposure to Europe, within the Midcaps Mastek, KPIT, Coforge, FSOL and Cyient have higher Europe exposure.

Small companies at high valuation discounts

Smaller IT companies are trading at a 44% discount to TCS, in line with past ranges.

LOOKING AHEAD

TCVs should help offset revenue slowdown; Telecoms and Retail may take a little longer

TCVs should help insulate growth in the next two quarters for large and mid-size companies.

While conversion to revenues in the short term (or lower ACVs) may induce slowness, visibility (tenure) of revenue goes up in larger deals.

Weakness in Telecoms and Retail may persist for some time; others may exhibit more resilience.

The fear of recession, lower tech spend and lay-offs in the US overblown, Indian IT job market normalised

Both the manufacturing and services sector revenue growth rates have decelerated but remain positive in US.

However, purchasing managers factoring in contraction in manufacturing.

Yet, the probability of a recession in US in H1 2023 is very low and even by end 2023, the probability is less than 40%.

Meanwhile, the inform sector job market in the US remains buoyant and tech spending plans much above pre-pandemic. IT job openings in India cooling off.

Just 10% higher trading multiples versus pre-pandemic for most

Current valuations for the top-10 IT companies (large plus mid) are now ~10% higher than pre pandemic levels, explainable through slightly higher growth and better margins (for mid-sized companies). At the aggregate level, the median FY25 PE is now 17x on our estimates, compared to the Nifty’s 16x.

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