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MOSL: TECHNOLOGY: Delay in supply normalization may cause a perfect storm in 3Q

Technology: Delay in supply normalization may cause a perfect storm in 3Q

Our conversations with managements in the IT Services space (as highlighted in our 2QFY23 result ) indicates sustained positivity around Enterprise IT spends, despite a slowdown in corporate growth. This has led to a continuation in supply shortages (leading to margin pressures), despite record employee addition and wage hikes. As we head into a slower third quarter, we see additional risk from this shortage, given the difficulty in executing a hard shift to excess supply from scarcity mode. While we factor in levers to control costs (cuts in sub-contractor and variable pay, higher utilization, freshers getting billable etc.) in our 3QFY23 base case for margin expansion, we see downside risks to profitability as the industry may lag in cost optimization measures due to the sudden shift. Margin pressures in a seasonally weak third quarter will lead to a perfect earnings storm and investor focus on near term pain at the cost of the long-term opportunity.

Revenue growth to remain muted in 3QFY23

• Commentary from our IT Services Coverage Universe over the last few weeks indicates continued positivity around the deal pipeline and enterprise tech spending. At the same time, most companies have limited demand visibility going forward, given the macro headwinds and possible recession in the US and Europe emanating from rising inflation and interest rates.
• Also, seasonal weakness in 3QFY23 is likely to further impact revenue growth and carries an additional risk of higher-than-usual furloughs.
• A significant depreciation of the EUR/GBP against the USD over the last month should put additional downward pressure on reported USD revenue growth.
• Our estimates suggest that median USD revenue growth is likely to moderate to 7.8% YoY in 3Q from 14.6% in 2QFY23 and 20.9% in 2QFY22.
• We continue to factor in limited impact from deal delays and pushouts, which may take place if the macro environment worsens further.

 

Downside risks to margins remain a concern

• Over the last few quarters, companies have hired employees in record numbers and provided unprecedented wage hikes to combat the supply shortage.
• Elevated employee cost, due to supply pressures, is likely to remain sticky in the near term as companies face supply shortages and prioritize growth (with a few exceptions like TECHM). This can lead to slower implementation of cost optimization measures in case demand slows.
• Companies have levers such as improved pricing, freshers turning billable, cuts in variable pay and sub-contractor expenses, which can aid margin in the near term. However, the risk of a hit on earnings remains high as these levers may take longer to play out.
• We have seen a few companies implementing a part of these levers to manage margins in 2Q, which can crimp their ability to fully utilize the same in 3QFY23.
• Any further dip in margins (assuming a bottom in 1HFY23, depending on the wage hike cycle) will meaningfully impact earnings growth in 3Q and raise concerns in the minds of investors, despite an unchanged long term picture.