IT stocks: Q2FY21 preview – Strong Q2 is priced in by valuations

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October 05, 2020 3:45 AM

While FY22 recovery hopes are intact, recent euphoria worrisome in the near term; LTTS downgraded to ‘Hold’

TCS, Infosys, Wipro, IT stocksFrom March lows of 10,937.37, BSE IT index has rallied over 90 per cent

Investor sentiment on Indian IT stocks appears buoyant driven by positive surprises in Q1FY21 and then the recent HCLT announcement. We continue to like the sector, especially in the medium to long term, but the recent euphoria is a little worrying to us near term. In the past six months, IT companies have seen revenue declines of 4-10%. Just a normalisation of some of the one-time issues themselves should drive decent growth in Q2FY21e. However, deal signings in Q2FY21 were not as strong as we had earlier expected, which does not bode well for Q3FY21e or even Q4FY21e. Based on typical seasonality, Q3FY21e could be a shade better but is unlikely to be materially better.

What to expect for Q2FY21e and upside triggers
We expect Infosys to raise its FY21 guidance to 1-3% growth (from 0-2%). No change in guidance could be a slight negative surprise for the investors in light of the recent re-rating of the sector. For HCLT, guidance for Q3 and Q4 is for 1.5-2.5% sequential growth as of now, and we don’t expect a change in this guidance, but if management alludes to higher confidence in the upper end of the guidance, that could be a positive surprise. We expect revenue growth of 1.2-3.5% q-o-q in constant currency terms across all the companies. On top of that, the cc impact is favourable, and hence, we expect reported growth in the range of 2.0-5.2% q-o-q in USD terms. Our margin outlook is now even better as we see 30-100 bps margin expansion q-o-q across all the companies. We see a decent buffer across the industry to invest in growth.

Our optimism for FY22e recovery intact
Pipelines across the sector are rich with deals, providing ‘cautious’ confidence for the medium term (FY22e/23e growth). Most companies have pipelines at 1.5x pre-COVID-19, on our estimates. These deals are related to cost rationalisation initiatives, vendor consolidation, supply chain reimagining, cloud migration, core simplification and some long-term business initiatives.

Our positive view for the IT sector also remains driven by its relative attraction versus the rest of the India market. At this stage, despite our not particularly positive view on H2FY21e, we expect IT earnings to be a lot more resilient versus the rest of the market given the long-term attractive compounding opportunities. We retain our Buy ratings on Infosys, HCLT and CTSH in large-caps and LTI and MphasiS in mid-caps. Downgrade LTTS to Hold.

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