HSBC rates TCS stock as Hold, flags rupee as a concern

By: | Published: September 4, 2017 1:43 AM

Company confident of demand picking up; while it has ability to drive through tech cycles, high base and valuations limit upside.

TCS, HSBC, TCS CFO V RamakrishnanTCS reported 23.4% margins in Q1FY18.

We met TCS CFO V Ramakrishnan and discussed demand and margin trends in detail. He reiterated that the sector is grappling with slower IT spend, evident in moderating growth rates, but that this could still reverse in the coming quarters. The margin outlook is more worrying given the INR’s strength. Many structural headwinds have pulled down sector growth, but macro weakness is a big contributor to the sector slowdown as well. Some of this spend may come back with improvement in the macro environment and the business outlook of IT clients.

Banking recovery – the centre of the discussion storm TCS’s growth has been pulled down by the banking, hi-tech and retail sectors while other sectors have done well. The CFO believes that slower banking growth is not linked to TCS’s high market or wallet share at some of the large US banks. Rather, banks are simply cautious to increase spending at this stage – although, with regulatory pressure expected to lessen and a continued pick-up in business, spending should grow in the coming quarters. TCS is strong in digital spend and has not lost market share. Top banks in the US report decent revenue growth and, if this recovery is sustained, management expects IT spend to pick up as well.

Retail slowdown may be more structural The CFO clarified that retail weakness is led by few small retailers who, unable to cope with the online attack, are losing business. While the base will become favourable at some stage, the online impact on the bricks-and-mortar business is structural and may continue to impact
IT spend.

Traditional vs digital

Though the pricing pressure the traditional business faces may be a little more than the historical average, the CFO believes higher realisations in the digital segment more than offset this impact. Clients value quality and certainty of delivery and do not focus only on pricing; companies such as TCS, with scale across technologies, can therefore withstand some pricing pressure in the market.

Margin outlook remains tricky

TCS reported a 23.4% margin in Q1FY18. In coming quarters, most of the wage impact of 150bp in Q1 should recover. However, that still means margin guidance of 26-28% may remain a challenge. Also, rupee strength is a serious headwind in our view. It’s fair to assume the business model requires 3-4% depreciation every year to absorb wage inflation.
Overall, we continue to believe sector growth in the recent quarters has been led by both structural and cyclical factors. Structural factors are unlikely to recede but the impact of cyclical factors may abate, driving acceleration from the current 6-7% sector growth rate. We like TCS’s ability to drive through tech cycles, but a high base and valuations limit share price upside – Hold.

Banking recovery – the centre of the discussion storm

TCS’s growth has been pulled down by the banking, hi-tech and retail sectors while other sectors have done well. The CFO believes that slower banking growth is not linked to TCS’s high market or wallet share at some of the large US banks. Rather, banks are simply cautious to increase spending at this stage – although, with regulatory pressure expected to lessen and a continued pick-up in business, spending should grow in the coming quarters. Growth in spend (focused mostly on digital areas) should accrue well to TCS, in the CFO’s view. TCS is strong in digital spend and has not lost market share. Top banks in the US report decent revenue growth and, if this recovery is sustained, management expects IT spend to pick up as well.

Retail slowdown may be more structural: The CFO clarified that retail weakness is led by few small retailers who, unable to cope with the online attack, are losing business. While the base will become favourable at some stage, the online impact on the bricks-and-mortar business is structural and may continue to impact IT spend.

Margin outlook remains tricky and exposed to rupee

TCS reported 23.4% margins in Q1FY18. In the coming quarters most of the wage impact of c. 150 bp in Q1 should recover, according to the management. However, that would still mean the margin guidance of 26-28% may remain a challenge on full year basis. Also, in our view rupee appreciation is a serious headwind. It’s fair to assume the business model requires 3-4% INR depreciation every year to absorb the wage inflation. In that context, even a stable INR is a headwind for margins in the medium to long term.

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