Equal weight rating on TCS: Mixed Q2 results

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Updated: October 23, 2015 6:14:00 PM

TCS has missed Street expectations on revenues for the last four consecutive quarters

tcs infosysRevenue growth in North America decelerated to 3.1% in Q2FY16 (vs. 4.4% in Q1FY16), whereas Infosys showed continued strong growth momentum.(Reuters)

Weak rupee and strong commentary could prevent any material EPS (earnings per share) estimate cuts after disappointment in Q2 revenues. However, P/E (price-to-earnings ratio) is at a 12% premium to Infosys, which could narrow, in our view.

Q2FY16 revenues missed expectations: TCS reported revenues of $4156m (+3% q-o-q, +5.8% y-o-y), below our estimate and the Street’s. EBIT (earnings before interest and taxes) margins (27.1%) and net income (R60.55 bn) were largely in line with Street estimates but lower than our expectations. TCS has missed Street expectations on revenues for the last four consecutive quarters.

However, strong commentary balanced out lower than expected performance in Q2FY16, in our view: Management indicated very strong order booking, broad-based across geographies and industry verticals, ruling out any concern with respect to the demand environment. Further, it maintains its commentary around a stable pricing environment.


The only headwinds which management pointed out were Diligenta and Japan, which could continue to decline in the near term.


Larger peer’s commentary for 2H remains divergent… Infosys’ outlook for 2H was clouded by unchanged F16e guidance and weak commentary pointing to incremental headwinds in business over and above seasonality. On the contrary, TCS maintained its positive outlook on demand, indicating seasonality in 2H to be in line with 2H last year
…but performance has converged: Despite divergent commentary around the outlook for 2H, we note that constant currency revenue growth for Infosys (~13% y-o-y) and TCS (~14% y-o-y) converged in 1HF16. Based on historical trends for TCS and guidance for Infosys, we expect that both companies could end up with constant currency revenue growth of 12-13% y-o-y for F16e.

Currency offsets cut to US$ revenue growth forecasts: After Q2FY16 revenues weaker than our expectations, we lower our US$ revenue forecasts for F16-18 by ~1% and margin assumptions by ~30bps. However, assuming a weaker rupee rate (~R65/US$) leads to cuts of less than 1% to our F16-18 EPS estimates. We forecast US$ revenue growth of ~9% y-o-y in F16 and Ebit margin of 27.1% for F16. Key downside risk remains weaker than expected 2H/lack of margin improvement in 2H compared to the current levels. One year forward P/E is 19.6x vs. 17.4x for Infosys and as the revenue growth gap closes, we believe multiples could also converge.

Sept-15 quarter’s results highlights

Reported revenues of $4156m (+3% q-o-q, +5.8% y-o-y) vs. Street consensus estimate of 3.6% q-o-q growth and our estimate of 4% q-o-q. Volume growth was 4.9% q-o-q, constant currency realisation dipped -1% q-o-q, and constant currency revenue growth was 3.9% q-o-q. Operating margin was 27.1% (+78bps q-o-q, +22bps y-o-y) vs. our estimate of 27.7% and Street consensus of 27.2%. Net income grew to Rs 60.55 bn (+6% q-o-q, +14.5% y-o-y) vs. our Rs 61.6 bn forecast and Street consensus of Rs 60.6 bn.

Key management commentary

According to management, the demand environment remains strong barring a few parts of the business (Diligenta, Japan). Latin America grew in Q2 and is expected to continue to grow in constant currency terms. According to management, order booking in 2Q16 was 30% higher than the highest ever order booking in any quarter historically. The energy vertical continues to face challenges; however, exposure to the vertical is small and unlikely to have any meaningful impact on revenue growth. Management expects 2H to remain weak, in line with previous year’s seasonality, with no incremental headwinds. The pricing environment remains stable and realisations could follow a historical trend of weakness in 1H and some strength in 2H.

Results positives

Revenue growth was broad-based across key verticals like BFSI, Retail, Life Sciences and Healthcare. Manufacturing was weak, primarily due to a decline in Japanese revenues. Traction was strong in Digital Services and Solutions. Net addition to headcount was over 10k in Q2, one of the strongest in the last several quarters. Management increased its gross hiring outlook for F16 from 60k to 75k.

Results negatives

Revenue growth in North America decelerated to 3.1% in Q2FY16 (vs. 4.4% in Q1FY16), whereas Infosys showed continued strong growth momentum. According to management, Japan and Diligenta will continue to decline over the coming quarters, hampering overall revenue growth for the company. Ebit margin in 2Q16 was lower than we expected. Margin in 1H was 26.8%, largely flat y-o-y despite ~6-7% y-o-y rupee depreciation vs. USD.

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