Sonata Software faces near-term growth challenges. Buy, hold or sell?

HDFC Institutional Equities on Wednesday highlighted that Sonata Software, known for its focus on modernisation engineering and AI-driven solutions, is currently experiencing a protracted phase of muted growth. The IT firm has faced a slowdown over the past four quarters, primarily due to client-specific issues with key partners such as Microsoft and in the BFSI segment, alongside broader macroeconomic headwinds affecting the retail sector.

Despite the ramp-up of large deals recently won, Sonata's Microsoft Dynamics (sell-to) business has been under stress, though it is expected to stabilise as investments in data, Dynamics CRM, and Fabric pick up pace, HDFC Institutional Equities said.

The brokerage noted that a major BFSI client for Sonata continued to operate under budgetary constraints, and this has led to ongoing weakness that is anticipated to continue into the second quarter. Retail and manufacturing divisions are also under pressure, attributed to global trade tariffs and shifting regulatory landscapes. The DPS business, meanwhile, is grappling with subdued IT/ITES demand and heightened price sensitivity, a situation compounded by Microsoft's direct engagement with large enterprise customers.

Sonata Software has set its sights on achieving an 18% IITS EBITDA margin by FY26E, with the impact of wage hikes in Q2 and Q3 considered. This target is supported by revenue stabilisation, an improved onsite-offshore mix, and better resource utilisation. However, HDFC Institutional Equities notes that the overall growth engine appears stressed and expects FY26E to remain muted, with consolidated EPS and IITS revenue CAGRs forecasted at 13% and 7% respectively for FY25-28E.

In light of the ongoing challenges and slow margin recovery, HDFC Institutional Equities has reduced its earnings per share estimates for Sonata Software by 7-8%. The brokerage maintains an 'ADD' rating, assigning a sum-of-the-parts target price of Rs 400, valuing the IITS business at 22 times and DPS business at 15x.

The partnership with Microsoft remains a cornerstone for Sonata, though it faces fresh challenges as Microsoft implements more methodical investment strategies and tighter budget controls. This has led to longer deal cycles and introduced risks associated with Microsoft’s evolving client engagement models, especially with larger customers. Notably, Microsoft's Dynamics growth, historically at 30-40%, has slowed to 15%, reflecting cautious spending by mid-tier US firms.

Within the BFSI space, pressures are most acute from a large US banking client contending with cost-control initiatives and reduced discretionary spends, a trend likely to persist into the coming quarters. While additions of new clients and stable core operations offer some offset, the performance of this particular client continues to weigh on the segment’s outlook. Meanwhile, both retail and manufacturing remain exposed to global softness and macroeconomic uncertainties, suggesting a gradual and uneven recovery path.

HDFC Institutional Equities has noted stabilisation in the healthcare and life sciences verticals, which had previously been affected by client-specific challenges. Growth in this segment is now being driven by pharmacy and health technology platforms that utilise modern and AI-enabled technologies, offering some encouragement amid the otherwise cautious outlook for the company's broader portfolio.