Tata Consultancy Services’ (TCS) Q2FY17 revenue, at $4,373 m (up 0.3% q-o-q, 1.0% in CC), was below Street’s 1.9% estimate due to weakness in Retail & CPG and BFSI verticals. However, operating margin, at 26.0%, surpassed Street’s 25.3% estimate. Management cited holding back of discretionary spends and slow ramp ups as key reasons for the revenue miss while ruling out project cancellations or structural headwinds. We continue to believe that TCS will underperform peers on revenue and margin fronts due to its investments in Insurance/ Diligenta, volatility in LATAM, Japan & India businesses and limited margin levers. While the stock correction limits substantial downside, limited near-term triggers cap upside. Maintain hold with revised TP of R2,320.
Revenue growth falters on tepid BFSI, Retail & CPG
Revenue, at $4,373 m, up 1.0% q-o-q on CC basis, was below muted estimate owing to mere 1.2% growth in BFSI and 3.1% decline in Retail & CPG, which together contribute 53.8% to revenue. Amongst geographies, while North America (54%) grew a tepid 1.4% q-o-q (CC), Latin America, UK and India declined 0.2%, 0.1% and 7.6% q-o-q (CC), respectively. Management highlighted that issues were largely temporary and there were no project cancellations or any other structural headwinds.
Operational efficiency enables margin surprise
TCS surprised positively on margin yet again with operational efficiency absorbing the 40 bps exchange fluctuation impact. It did a commendable job of arresting attrition—fell to low of 11.9% for IT services—which we believe will spur margin improvement (CC). We cut FY17e and FY18e revenue 3.2% and 4.2% to factor in weak Q2FY17 revenue growth, leading to 1.8% and 3.6% cut in FY17e and FY18e EPS, respectively.
Outlook and valuations: Low growth; maintain hold
We believe, the tepid 0.3% revenue growth, even assuming some course correction in H2, implies sub-7% USD growth for FY17 with concerns in key verticals such as BFSI and Retail & CPG. Although TCS has demonstrated ability to maintain margin in a narrow band despite revenue underperformance, in the process it has exhausted margin levers. Hence, margin improvement will be a herculean task in the absence of revenue growth. We maintain hold/sp with revised target price of R2,320 (16x FY18e EPS; R2,410 earlier). The stock is trading at 17.5x and 16.1x FY17e and FY18e EPS, respectively.
6-7% revenue spurt, 26% margin achievable
TCS, yet again, missed revenue estimate by >100bps. While management does not foresee structural issues or project cancellations, the fact remains that it has disappointed over the past several quarters. In our view, one or more of the following 4 issues individually or cumulatively have led to revenue disappointment: (i) Diligenta business; (ii) Japan; (iii) LATAM; and (iv) India. While individually they are minuscule, disappointments from them have coincided with cross currency pain and delays in other businesses, compounding problems. We continue to believe that while further disappointments in the above 4 areas are unlikely, their contribution to growth is still some time away. This intensifies pressure on other businesses to perform, which appears difficult given the current volatile global environment. We will closely monitor any turnaround before we reassess our recommendation. We believe, in the current situation characterised by cross currency impact and volatile global macros, TCS can clock 6-7% revenue growth with 26% margin in FY17e, which does not warrant any change in our 16x target multiple.
Growth pangs in key sectors, geographies
TCS missed revenue estimate led by weak growth in BFSI (1.2%), sharp decline in Retail (-3.1%) and India business (-7.6%). Management highlighted that while revenue miss in BFSI was anticipated, Retail slowdown came as a surprise. With macro concerns emerging from Brexit, specifically related to BFSI (contributes 40% to overall revenue), we believe TCS will find it difficult to return to industry average growth rate. QoQ weak 1.5% growth in highgrowth digital business is a disappointment, although a large part of that would be a derivative of weak Retail growth.