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IT preview: Brace for drop in Q1 margins! Brexit commentaries under watch

The June quarter is believed to be seasonally stronger quarter on revenue front, but IT firms may see weaker margins this time due to wage revisions and additional visa costs.

Aprajita Sharma  New Delhi     Last Updated: July 8, 2016  | 08:45 IST
IT preview: Brace for drop in Q1 margins; Brexit commentaries under watch
Photo: Reuters

Top four IT players TCS, Infosys, HCL Tech and Wipro are expected to show divergence in June quarter earnings, with the former two likely to report better organic growth than the latter two in a seasonally stronger quarter.
 
However, for the Street to reward the otherwise beaten down IT stocks, it is management commentaries over the contingency plans they will deploy to withstand the impact of Britain's exit from European Union (EU), which will soothe nerves of investors in the near future.
 
Europe accounts for a major proportion of revenue for domestic IT firms and, thus, hold paramount importance to IT firms and the Dalal Street investors.
 
Expect strong top line, but weaker margins
 
The June quarter is believed to be seasonally stronger quarter on revenue front, but IT firms may see weaker margins this time due to wage revisions and additional visa costs.
 
Brokerages expect the top four IT companies to log sequential revenue growth of 2.0-6.6 per cent in the June quarter with HCL Tech (6.6 per cent QoQ, 3 per cent organic growth) leading the pack. It is expected to be followed by Infosys' 4.2 per cent organic, TCS' 3.1 per cent and Wipro's 2 per cent QoQ rise in Q1FY17 revenues.
 
In dollar terms, the revenues are expected to grow by 2-5.3 per cent quarter-on-quarter. Margins will also take a knock to the tune of 70-170 bps.
 
Brexit plans hold the key to stock performance
 
The UK is the second biggest market for large domestic IT firms, accounting for 25 per cent of their market. It would take about two years for Britain to completely exit the EU. During the phase, the EU and Britain will re-negotiate terms and conditions of their trade, which will have a bearing on discretionary demand for the domestic IT companies focusing on the region.    
 
The stocks of the tier-1 IT companies have fallen up to 5 per cent in the last one month, and may shed even more, if the management commentaries lack confidence over their Brexit plans.
 
The immediate and foremost impact would be seen on the demand from the banking, financial services and Insurance (BFSI) segments. This vertical has already been under pressure of late.
 
Pound crisis intensifies, but impact on Q1 minimal
 
The British pound and the euro have had a huge knock against US dollar in the aftermath of Brexit. The British currency is, in fact, ruling below 31-year lows. Brokerage Prabhudas Liladhar believes this will adversely impact revenues of IT firms in dollar terms. They may, however, have no impact on the constant currency revenues.
 
"Assuming nearly 10 per cent depreciation in euro and pound, dollar revenue impact for most companies could be nearly 1.5?2.5 per cent, and the combined (revenue and margin) earnings per share (EPS) impact could be nearly 4?7 per cent, " said Prabhudas Liladhar in a research report.
 
As per their analysis, rupee depreciation of 3?4 per cent will be required to offset the EPS decline.
 
Motilal Oswal believes pound's depreciation should not hurt the performance for the industry in Q1FY17 as volatility across currencies accelerated only towards the end of the quarter.
 
However, if the currencies continue to tread within the current band, it said, the impact will unfold in the second quarter.
 
While TCS' exposure is the highest, the brokerage doesn't see it impacted the most thanks to the negating effect of Japanese yen's appreciation.
 
Wage hikes and visa costs key margin detractors
 
Infosys and TCS will announce wage hikes, which will be effective April 2016 (1QFY17). The hikes would have an impact on IT firms' margins. The rise in visa costs will further dent margins.
 
Centrum Broking expects EBITDA margins for tier-1 IT vendors to drop by 90-200 bps in the June quarter on a sequential basis.
 
Brokerage Edelweiss expects margins for TCS and Infosys to fall 170 bps and 110 bps QoQ, respectively, Wipro's margin could tumble 70 bps (1-month wage hike impact), HCL Tech's margin may contract 170 bps on lower margin inorganic business and visa cost, while Tech Mahindra's margin is likely to dip 110 bps due to lower Comviva revenue, visa cost and lower margin revenue from merger.
 
Going ahead, commentary on margin levers and ability to negate pricing pressure in traditional services will be key monitorables, the brokerage said.

Stock view

For Motilal Oswal, Infosys and HCL Tech stocks remain the top picks.

"Given the traction in revenue growth and at Infosys under new leadership, we take greater comfort in its valuations, compared to TCS, where challenges in  nearly 20 per cent of portfolio , and higher base, resulted in deceleration of growth rates last year - a risk to premium multiple," said Motilal Oswal.

As for HCL Tech, the stock is trading at a 21 per cent discount to Sensex, compared to the historical average of 14%, owing to margin risk. However, the brokerage said, potential of double-digit organic growth (substantiated by order book), better growth compared to Tech Mahindra and Wipro,
along with 25 per cent+ return on equity (ROE) leaves ample room for upside despite embedding
conservatism on the margin outlook.

For Edelweiss Securities Infosys continues to remain the top pick. The other two largecap stocks that it prefers are Tech Mahindra and HCL Tech.

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