Q3 FY16 Preview for IT: Traditionally a weak quarter

Weakness in revenue growth would get reflected in operating margins for most players as operational levers such as utilization, SG&A leverage and offshore shift would be elusive for extraction.

The third quarter of a fiscal year has traditionally been a weak period for India IT companies characterized by lesser number of working days and furloughs at the client’s end. This time around some many companies would face additional growth headwinds on account of general weakness in the energy and telecom verticals and client specific setbacks. A couple of large companies have also alarmed about growth being impacted materially due to the Chennai floods which temporarily disrupted execution from the centers located there. The further strengthening of dollar against other functional currencies would lower reported sequential revenue growth by 40-70bps.
 
We broadly see large IT companies under our coverage to report qoq dollar revenue growth in the range of 1-2% in constant currency terms with HCL Tech and Tech Mahindra delivering near the upper end. Amongst the mid-sized players, we estimate Cyient to deliver a strong growth of 4-5% qoq while Mindtree would report a muted 1% qoq growth as seen in the preceding years. In line with its latest commentary, Infosys would deliver a tepid growth of 1.4% qoq in CC terms during Q3 FY16 due to seasonality and lower spending by top clients. TCS has already published that disruption at its Chennai facility (one of its largest delivery locations with over 65,000 employees) is likely to have a material impact on revenues of the quarter. For Wipro, apart from impact of this event (22,000 employees in Chennai), persistent weakness in Energy vertical (15% of revenues) would be a headwind pushing growth delivery towards the lower end of guidance (0.5-2.5%). Tech M may also report a moderated growth in Q3 FY16 on the back of consolidation within customers which has driven slowdown in decision making.
 
Weakness in revenue growth would get reflected in operating margins for most players as operational levers such as utilization, SG&A leverage and offshore shift would be elusive for extraction. Despite the likely 30-40bps benefit from the depreciation of rupee, we expect 20-60bps qoq reduction in operating margin for our coverage companies barring Tech Mahindra (25 bps expansion), Persistent (20 bps expansion) and Cyient (40 bps expansion).  
 
We continue to maintain a Neutral view on the sector as the investment risk-reward currently is in balance. Large caps are fairly priced at 13-17x FY17 P/E for an estimated modest earnings CAGR of 8-12% over FY15-17. However, significant rupee depreciation could be a positive earnings catalyst in the near-to-medium term. Our preferred picks in the sector are HCL Tech, Infosys and Mindtree.