For IT stocks, deal win momentum, margin pressures key factors in Q4

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 3 min read . Updated: 04 Apr 2021, 11:31 PM IST Harsha Jethmalani

The March quarter is considered to be seasonally weak for the Indian IT services sector. But this time is different. Major technology companies could post robust earnings growth in Q4FY21, thanks to a relatively low base last year, when business was hit in March-end owing to the coronavirus outbreak. The Street’s optimism is also stemming from the buoyant deal activity that many IT companies have been talking about. Expectations are that increased spending on digital transformation by clients would keep the deal pipeline for IT companies healthy.

Recent deals between Tata Consultancy Services Ltd (TCS) and Vodafone, Infosys Ltd and Siemens, and HCL Technologies Ltd and Airbus, among others, point to an uptick in manufacturing and communications verticals, analysts say.

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Second, read-through from improved growth outlook by global IT firms Accenture and Capgemini augurs well for the demand outlook of Indian companies, they add.

However, some analysts are of the view that the deal-win scenario may not be as robust as it seems, and investors should not get carried away by it.

“Excluding Infosys and Mphasis, 9MFY21 deal wins are 17-69% lower than FY20 levels for other IT companies," analysts at Ambit Capital pointed out in their earnings preview report. Their analysis shows that for even 10% growth in deal wins in FY21 (ex-Infosys/Mphasis), Q4 deal wins have to be materially higher than last three-quarter average for other firms.

“This is key for elevated street expectations to be satisfied," said the Ambit report. In other words, while there is much talk and excitement about deal wins, the hard numbers on this aren’t all that high.

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Meanwhile, there is an emerging margin headwind for the sector from recently announced salary revisions and bonuses. Analysts estimate, wage hikes to be in the range of 100-200 basis points (bps) for tier-1 IT companies and around 250-300bps for tier-2 companies. One basis point is one-hundredth of a percentage point. So, investors should brace for some pressure on margins starting to reflect in March quarter earnings.

Analysts at Kotak Institutional Equities estimate Infosys, Wipro, Larsen & Toubro Infotech and Mindtree to report a sequential Ebit margin decline of 115-180bps. Ebit is short for earnings before interest and tax.

“TCS has already absorbed wage revision in the previous quarter and will accordingly report Ebit margin increase. Ebit margin of Tech Mahindra, LTTS and Mphasis will be stable or increase marginally," said the Kotak report dated 1 April. Apart from that, another downside risk to margins could come from higher attrition rates and the supply side pressures the industry is facing.

Against this backdrop, some analysts are not comfortable with the valuations of key IT stocks. Valuations of tier-1 IT companies are higher than their respective long-term averages and also relative to the benchmark Nifty IT index. The one-year forward price-to-earnings ratio of TCS is currently at around 30 times, showed Bloomberg data. Peers Infosys and Wipro are trading at PE multiples of 27 times and 21 times, respectively.

The Nifty IT index is trading at a one-year forward PE of 20 times. Talking about the overall industry valuations, according to analysts at Motilal Oswal Financial Services Ltd, the sector trades at a 39% premium to its 10-year average multiple.

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