TCS’ constant-currency (c/c) revenue growth of 2.1% in Q4FY16 was backed by solid revenue growth in core markets and improvement in client metrics. Ebit margin decline of 50 bps disappointed, which the management attributed to accelerated investments in digital business. With reduced drag to revenues from peripheral markets and Diligenta, the growth trajectory shall improve sequentially even as the net result will still be a slower growth in FY2017. Maintain EPS estimates and rating. Target price increases to R2,650 on roll-forward, valuing TCS at 17X FY2018e earnings.
Solid Q4 revenue growth; key metrics healthy
TCS delivered c/c revenue growth of 2.1%, in line with our estimate. Core markets performed well. US grew 2.4% q-o-q and Continental Europe by 3.6%. BFSI grew 3.2% and manufacturing by 3.9%. Digital revenues grew at a robust rate. Client metrics improved with the number of $100m clients increasing by 3. Net hiring was strong at 9,152 employees. Ebit margin declined 50 bps as compared to our expectation of improvement. Decline was despite 60 bps benefit to margin from rupee depreciation. Net profit of R63.4 bn was 2.1% ahead of our estimate due to forex gains of R1.92 bn.
Margin outlook—digital investments could move FY2017e Ebit to lower end of 26-28% band
A section of the Street is bound to believe that the margin decline in the quarter is due to pricing pressure resulting from defence of share of business. While pricing decline could be one plausible reason, we understand that the larger chunk of decline is on account of accelerated investments in digital labs, solutions and increasing visibility for its products, solution and platforms to capture the fast growing digital business. These investments will continue in FY2017 and act as additional headwind besides higher local hiring at onsite. Result—FY2017 Ebit margins will be at the lower end of 26-28% Ebit margin band.
Expect moderate 10-11% revenue growth in FY2017
Even as the impact of drag elements of FY2016, viz. Diligenta, Japan and LatAm will reduce in FY2017, growth will still be a modest 10-11% due to poor exit rate. Management believes that strong core markets (financial services, North America and Europe), improvement in growth and scale of digital business and lesser drag from verticals and geos, position the company well for growth in FY2017.
Broadly maintain estimates; TP increases by 5% to R2,650 due to roll-forward
We maintain our FY2017-18e revenue growth estimates. We reduce our Ebit margin assumption by 70 bps for FY2017. Impact of change in margin estimate is offset by below Ebitda items. TCS in our view is set to achieve lowered growth expectations. We value the stock at 17X FY2018e earnings leading to TP of R2,650 (R2,525 earlier).
Expect steady revenue growth in FY2017
We forecast c/c currency revenue growth rate of 11.2% in FY2017 in line with the Nasscom growth guidance. Despite elimination of some of the drag elements of growth, we expect only a marginal acceleration in revenue growth rate. We detail factors for our modest growth assessment:
Higher exposure to traditional services: Constrained IT budgets and business imperative to spend on digital imply self-funding mechanism, i.e. through cost take outs in traditional services to fund digital. Vendors are achieving the desired cost savings for clients through managed services, fixed priced contracts and pricing concessions. Vendors’ disproportionate focus on these services has only accelerated the pricing decline. This trend is unlikely to reverse in FY2017.
Discretionary spending has many new competitors: Nearly the entire discretionary spending is digital-led. Indian IT’s share in discretionary services is lower than what it used to be due to (i) fragmentation with many new players targeting the growing discretionary pie through new and disruptive business models and (ii) consulting-led growth in any technology and business changes in the early phase of evolution. While TCS has invested in digital and has the most robust digital practice among Indian IT, it may miss out on consulting-led transformational engagements.
Greater challenge for share gains: While TCS continues to gain share of business, the pace of share gain has slowed down. TCS capitalised on poor execution of some of the competitors such as Infosys. Such share gains are now difficult to come by. Competition is hungry and more than willing to trade margins for revenue growth.
We, however, refrain from arguing for a structurally lower growth rate for TCS every year. We believe that the larger opportunity in the market will be full stack integration and simplification of systems; something for which TCS is well positioned. In fact, TCS management indicated that FY2017 will see large scale mainstream full stack deals, not a part of our base case assumption.
TCS is well positioned in digital business
TCS’ digital practice grew 15% q-o-q and constituted 15.5% of overall revenues. TCS has built up impressive capabilities that are accepted by clients. These aspects reflect in:
Depth, breadth and scale of digital projects: TCS has executed several large digital projects for marquee clients in scale verticals and is the primary digital partner of its largest clients.
Strong partner ecosystem: TCS has access to an ecosystem of 1,400+ startups of which it has selected 38 vendors for joint-go-to-market or developing joint offerings with these startups.
Large scale digital learning infrastructure: TCS offers anytime, anywhere, any device learning in 305+ competencies through an immersive learning platform and connected classrooms; 120K+ employees have leveraged it
Creation of IPs: TCS has created and commercialised a number of tech, horizontal and vertical industry products/platforms—DreamUP, Activearchive, Ignio, TCS Mastercraft, TCS Cloud, BaNCS, iON, ADDIP, Optumera are some of the IPs showcased by the company recently.
The management cited that it is the prime digital partner of 52% of its customers. TCS had identified the shift in market and customer spending early and made investments to build capabilities spanning verticals and technology areas. Given its ‘business first’ approach, it has made significant progress in taking in-house lab innovations to clients and converting it into successful real-life projects. We believe TCS has done hard work and building blocks are in place to sustain its leadership.
Pullback in disclosures disappointing
TCS has stopped disclosing utilisation rates. This comes after the company stopped onsite:offshore revenue mix and revenues from T&M and fixed price projects starting June 2015 quarter. The management indicated that these metrics have become less relevant and are not consistent with the evolution of the business model. This effectively has killed, whatever little was remaining of supply side driven earnings model of sell-side.
TCS believes that the business is truly heterogeneous with different parts of the business having a different rhythm that cannot be clubbed in simple traditional metrics. We do not completely disagree with TCS’ assertion; we look forward to more relevant disclosures especially for platforms and products businesses that run on completely different rhythm.
Expects significantly lower gross hires in FY2017; moves away from bell curve for performance ranking
TCS has announced wage increase of 8-12% at offshore and 2-6% at onsite. The company has discontinued bell curve for performance ranking. Performance ranking is now based on individual performance. TCS expects attrition levels to stabilise. Improved employee retention and better automation-led increase in productivity will result in reduced hiring in FY2016. The management indicated that it will hire 32,000 freshers from campus in FY2017.
TCS has filed one-third work visa applications in US this year as compared to last year. The emphasis is on local hiring in US and other onsite locations.
FY2016 roundup—a year of deceleration in revenue growth
Management attributed the deceleration in revenue growth in FY2016 to 11.9% in c/c to four factors—(i) Diligenta ramp down and (ii) underperformance in non-core markets i.e. Japan and India. In addition to these, the following challenges also impacted—(i) no easy market share gain as some of the underperformers have started gaining share and (ii) client specific challenges. All these factors resulted in FY2016 c/c revenue decelerating to less than 11.9%, down from 17% in FY2015. Revenue growth in US$ terms was 7.1% on account of 480 bps cross currency impact. Ebit margin declined 50 bps to 26.5%.
Key highlights from Q4FY16 earnings call
Commentary on FY2017 outlook: TCS management indicated robust demand outlook in key verticals: (i) BFSI vertical (41% of revenues). BFS grew 14.8% in c/c terms in FY2016. Weakness in insurance (largely Diligenta) resulted in 11.8% growth in BFSI. TCS expects BFSI growth to improve in FY2017 led by sustained growth momentum in BFS and stabilisation/ improvement in insurance, (ii) besides BFSI, TCS expects robust growth in other key verticals such as Retail, Manufacturing, Life Sciences, Travel and E&U. It also expects Telecom and Media to recover after a challenging year. The management is cognisant of weak exit rate this year as against a year ago but is comfortable given a better outlook this year as against last year.
Segmental sequential growth in constant currency: Volume growth during the quarter was 3.2%. C/c sequential growth was steady across most verticals— BFSI +3.2%, Life sciences +1.2%, Hi-Tech -1.5%, Manufacturing +3.9%, Telecom +1.3%, Retail & distribution +2.1%, Energy & Utilities +3%. On geographic front, North America reported 2.4% sequential c/c growth, UK declined 0.4% c/c and Continental Europe grew 3.6%. Among service lines, Engineering services grew +5.8% q-o-q (c/c), IMS grew +2.2%, asset leveraged solutions grew 18.5% and testing grew 4.5%.
Margin walk-through: Ebit margin declined 60 bps q-o-q and 140 bps y-o-y to 26.1%. Management indicated that 60 bps benefit of rupee depreciation was negated by 120 bps decline in margins (business impact).
Deal wins: TCS has disclosed 7 wins spanning verticals and geographies—5 in North America,
1 in UK and 1 in Continental Europe.
w Client metrics: TCS reported solid progress in client metrics—it added 3 clients during the quarter (and eight in FY2016) to $100m+ bucket taking the count to 37. The number of $50m + clients was up by 8 q-o-q to 73.
