Hold rating on TCS; Skating on thin ice

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Published: July 20, 2015 12:03:32 AM

High base and transition in IT business model render even low- to mid-teen growth demanding

Tata Consultancy Services’ (TCS) Q1FY16 revenue at $4,036m (up 3.5% quarter-on-quarter) was below the Street’s modest 4.0% growth estimate. Ebit  margin at 26.3% (down 90bps q-o-q) was ahead of Street’s 25.7% forecast. TCS stated that its digital exposure @12.5% of revenue is growing in double digits q-o-q. It also reiterated robust demand scenario and a healthy pipeline, aided by US recovery and digital technologies.

In our view, while the revenue growth miss is marginal, CQGR (compounded quarterly growth rate). for the balance quarters is demanding given TCS’ higher dependency on H1. We believe the company will not be able to breach 11% revenue growth in FY16e, which will raise questions on the high multiples it enjoys. While we respect TCS’ market leadership, flawless execution and high returns, we believe 20x multiple for 11% revenue growth is a tad demanding and needs to moderate.

Based on lower Q1FY16 growth and higher H1 dependency, we cut our FY16e USD revenue growth to 11.0% (14.0% earlier) resulting in 3.5% and 3.2% cut in our FY16e and FY17e EPS (earnings per share), respectively. We downgrade the stock to Hold from Buy with a revised target price of R2,530 (18x FY17e EPS; R2,900 earlier).

Revenue miss; margin solace: TCS’ Q1FY16 revenue at $4,036m, although up 3.5% q-o-q, once again missed estimate. Ebit margin surpassed Street estimate. BFSI (banking, financial services and insurance) retail, telecom and life sciences posted robust growth, but manufacturing was flattish on soft- ness in Latin America and Japan.

Revenue productivity to improve: TCS maintained positive demand commentary and stated that its digital business is growing in double digits. Based on its guidance of 60,000 addition and 14% attrition assumption for FY16, we estimate net employee addition at 5% and revenue growth of 11%. This reiterates our thesis that the sector will clock higher earnings growth than revenue growth, led by productivity gains.


Rationale behind stock downgrade: TCS has been posting industry leading growth over the past few years. We believe its high base (despite it breaking down the entire business into 23 different businesses) coupled with current transition in the IT business model (aggressive adoption of digital technology and automation) render even “low to mid teen” growth demanding. TCS, despite having all the requisite arrows in its quiver, has been disappointing for four quarters in a row on revenue growth. Second, the company, by virtue of presence in multiple geographies and verticals, is skating on thin ice, wherein a miss from any vertical/geography/service is enough to dent the growth rate.

Consistent rise in attrition rate, from a bottom of 9.4% in Q4FY13 to 15.9% in Q1FY16 (despite a huge one-time bonus of R26.8 bn in Q4FY15) is a concern. While increase in Q1FY16 is due to seasonality, we are more concerned about its loss to competition. We believe replacement cost in the industry is very high and sustained high attrition may dent margin in the future.

TCS has amply squeezed significant benefit of shifting to the fixed price model over the past few years. Ergo, incremental margin lever remains limited, if not nil.

Scope for improvement here onwards will be gradual and slow, which caps positive margin surprises, going forward. We strongly believe that the industry is moving to the 10-12% revenue growth phase over the next three-five years riding strong momentum from adoption of digital technologies and automation of traditional business. While revenue growth will be in low double digits, earnings growth will be in teens, implying improving margins due to rising revenue productivity.

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