KRChoksey has issued an ACCUMULATE rating on Sonata Software Limited with a revised target price of Rs 679, offering a potential upside of 7.5% from its current price of Rs 632. Sonata's Q2 FY25 results exceeded revenue expectations, driven by significant growth in domestic operations. However, margins remained under pressure due to increased operating expenses tied to large deal ramp-ups and investments in strategic sectors like healthcare and BFSI. The company's strategic push into AI and cloud services, alongside recent client wins in the U.S. market, underscores long-term growth potential despite near-term margin challenges.

Financial Performance Overview

Revenue Growth: Sonata’s Q2 FY25 revenue rose by 13.5% YoY to Rs 21,698 million, bolstered by robust growth in domestic business despite a sequential dip of 14.1%. The increase reflects a solid demand trajectory across key sectors.
EBIT and Profitability: EBIT reached Rs 1,443 million, a slight 1% QoQ improvement, but down 12% YoY, with EBIT margins at 6.7%. PAT for the quarter stood at Rs 1,065 million, a 14.2% decline YoY, influenced by increased expenditure in expansion initiatives.

Margin Impact: Operating expenses rose due to workforce expansion, rebadging of personnel, and ongoing investments in AI and strategic verticals, contributing to a YoY decline in EBIT and PAT margins by 192bps and 158bps, respectively.

Growth Strategy and Strategic Wins

Expansion in Key Verticals: The U.S. contributed 72% of Sonata’s revenue, reflecting a 17.2% YoY increase in the region. The company also saw growth in TMT (33.1% YoY) and BFSI (17.6% YoY) verticals, indicating strong market positioning.
Major Deal Wins: Sonata secured three substantial deals this quarter, including data modernization for a leading U.S. financial institution and cloud services for a prominent technology company. Additionally, Sonata won two strategic mid-sized deals with new clients in the U.S. and Australia.

Investments in AI and Cloud: Sonata is focused on ramping up its AI capabilities, with a target to derive 20% of revenue from AI-enabled services by FY27. The company’s current AI pipeline stands at USD 67 million, representing a key area of growth over the next three years.

Operational Updates and Workforce Expansion

Employee Growth and Upskilling: Sonata’s workforce reached 6,485 employees in Q2 FY25, marking a YoY increase of 393 personnel. The company has trained approximately 83% of its engineers in generative AI, signaling a strong commitment to upskilling in cutting-edge technologies.
Utilization Rate: Utilization remained high at 87%, indicating effective resource allocation despite rising project complexity and new client on-boarding demands.

Strategic Talent Initiatives: Sonata implemented a salary hike for junior management in July and plans to extend this to mid- and senior-level employees in Q3 FY25, demonstrating a commitment to talent retention and motivation.

AI and Digital Transformation Goals

AI Revenue Targets: Sonata’s strategic focus on AI aims to contribute 20% of total revenue by FY27, aligning with the company’s goal of reaching USD 1.5 billion in revenue by FY27. The company is actively developing its AI and data transformation capabilities to support this target.
Strengthened Cloud Pipeline: Sonata’s cloud and data pipeline now constitute over 50% of its overall pipeline, a dramatic rise from 15% two years ago. This shift emphasizes the company’s dedication to high-growth digital services in cloud and AI.

Shareholding Pattern and Market Sentiment

Institutional Backing: Promoters hold a 28.2% stake in Sonata, with FIIs and DIIs collectively owning 35.5%, reflecting strong institutional confidence in Sonata’s growth narrative.
Stock Performance: The stock trades at a trailing 12-month P/E ratio of 33.5x, with KRChoksey maintaining its ACCUMULATE rating based on the company’s strategic initiatives in AI and cloud. The revised target price factors in near-term margin pressures while accounting for the long-term growth potential.

Guidance and Risk Considerations

Guidance on Margins and Earnings: KRChoksey has lowered its FY26 EPS estimate for Sonata to Rs 26.1 (from Rs 26.7), reflecting anticipated margin pressures from upfront costs tied to large deals. The target price of Rs 679 is based on a 26x P/E multiple for FY26.
Potential Risks: Sonata’s earnings may face short-term headwinds from macroeconomic factors, particularly inflation in the U.S., impacting client spending. Additionally, any delays in margin recovery due to ongoing investments in large deals could impact profitability projections.

Investment Perspective

KRChoksey’s *ACCUMULATE* rating on Sonata Software emphasizes its strategic push into high-growth areas such as AI and cloud services. Despite near-term margin challenges, the company’s solid client wins and continued investment in advanced digital technologies position it well for long-term growth. The stock presents a balanced investment opportunity with moderate upside potential for investors with a medium- to long-term horizon.