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Buy Sonata Software LtdFor Target Rs.660

Sonata’s IT services revenue was $58m (TTM $224m), up 2% q/q (4% cc), 14% y/y organic ($ terms, est.) and ~20% cc. Headcount (up 16% y/y) addition shot up to 406 (300 freshers) from just 36 last quarter. The margin was 23.5%, up 108bps q/q, with the bulk of the cost pressures behind. The company will continue to invest in building the sales team but not much pressure on margins is anticipated ahead as investments will be gradual. DSOs went up but are still within the medium-term range. The India business continued on high growth. We increase estimates ~5%; target retained at Rs.660 (bonus adjusted), 15x FY25e.

Looking for acceleration ahead, targets ~20% CAGR for IT Services. Sonata recorded a ~4% CQGR ($ terms) in the last four quarters, taking Q2 y/y growth to ~20% cc. It also signed two large deals in Q2 and the quarter’s hiring suggests continued growth expectation ahead. With the sales team being gradually strengthened, the management expects to retain current growth rates in the next four years and double IT services revenues by then. DSOs for IT services are going up to support growth, but remain within the industry’s and Sonata’s past range. Any further corrosion could be a cause of concern.

Bulk of margin pressures behind, wage hikes scheduled in Q4. IT services’ Q2 EBITDA margin was 23.5% (up 108bps q/q, but y/y down 144bps), absorbing the impact of sales investments in the last two quarters. Further, the investments are likely to be more gradual and in line with sales growth; hence, margin pressures may not be high. Wage hikes are scheduled in Q4 but, given the present supply situation, it is unlikely to be higher than last year. We expect Sonata to deliver ~23% in FY23 and 22.5% in FY24.

Rs660 target unchanged, 15x FY25 EPS. We introduce FY25 and roll our valuation multiple forward. Sonata’s IT business is likely to clock a 15% CAGR, with margins returning to 23% by FY25. Its India business is likely to record a 21% EBITDA CAGR, taking consolidated FY25e EPS to Rs44. The stock trades at 11x FY25e EPS (5% FCF yield), which we find attractive. Risk: Higher retail and europe exposure.

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