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MOSL: TECHNOLOGY | 2QFY23 PREVIEW: Continued margin pressure and FX to drag Q2 earnings

Technology | 2QFY23 PREVIEW: Continued margin pressure and FX to drag Q2 earnings

Commentary on weakening macro and adverse FX to be monitored

• Our IT Services coverage universe should deliver median revenue growth of 4.2% QoQ and 15.4% YoY in CC terms in 2QFY23E. Growth in EBIT/PAT (5.9%/9.1% QoQ) should be aided by seasonal margin improvement, although the impact is muted due to continued supply side pressure.
• With a weakening macro environment and looming fears of recession, we will be watchful of any moderation in the demand commentary across both Tier I and Tier II companies in the IT Services space. While our recent discussions with various managements indicate continued spends on technology services, we expect some impact across sectors (led by Retail and Manufacturing) for the remaining part of the year. The growth deficit in Tier I players v/s Tier II peers will further narrow in 2QFY23. We see a limited change in the FY23 revenue growth guidance of INFO, HCLT, COFORGE, and LTTS in 2Q, given the unchanged demand commentary.
• Despite 2Q being a seasonally strong quarter, revenue growth of Tier I companies should be ranging from 2.0% to 4.3% QoQ CC. While Tier II players are expected to grow in the (0.2) -5.1% range, CYL is expected to grow by 11.1% QoQ CC due to a meaningful contribution from recent acquisitions. Reported USD growth will be hit by 1.0-2.5% due to FX headwinds.
• Though slow-down in the US and Europe and a highly inflationary environment will impact 2HFY23 and FY24, on the longer term, demand would remain intact. We are trimming our FY23/FY24 INR EPS despite a positive impact due to the 300bp+ depreciation in INR (to 81.5/USD).
• The commentary on demand and impact of the weakening macro-economic outlook on deal conversion will be key monitorables.

INFO/CLY to lead revenue growth within the Tier I/midcap space

• We expect narrow revenue growth in the Tier I IT space, with INFO leading with a revenue growth of 4.3% QoQ CC, followed by WPRO/TCS at 4.2%/ 3.5%. HCLT/TECHM is expected to deliver 2.8%/2.0% QoQ CC growth.
• Among Tier II players, we expect CYL to grow 11.1% QoQ CC, buoyed by gains of ~900bp from recent acquisitions. We expect MTCL/PSYS/COFORGE to grow by ~5% CC.

Margin to remain mixed bag; Tier I players to see some margin recovery

• Operating leverage should result in some margin improvement in 2QFY23, although the gain will be modest due to continued supply-side pressure with elevated attrition and individual impact from wage hikes. While margins for Tier I companies will expand in the 10bp to 40bp range QoQ, Tier II pack will operate in a wider range (-90bp to 160bp). However, Zensar should see large 240bp sequential contraction on salary hikes along with revenue decline.
• Among Tier I players, margin recovery to remain muted for INFO and TECHM due to elevated supply pressures. In the Tier II pack, ZENT/PSYS/LTTS/CLY/MTCL to see a margin dip of -240/-90/-80/-80/-70bp QoQ, respectively, on account of wage hikes.
• Attrition levels are expected to remain at elevated and supply will continue to stay constrained, leading to increased replacement costs. Freshers becoming billable should provide near term respite in terms of margin.
• We see pricing flow through as a key monitorable over the next few quarters as the commentary from across the universe is indicating partial price comfort on deals/renewals. The pricing should start reflecting in profits with some lag.
• INR has meaningfully appreciated against EUR and GBP as these currencies have depreciated against USD. This will have a meaningful impact on FY23 and FY24 earnings for our coverage companies.