Q3 in line with estimates; high dividend yield is likely; target multiple up to 18x from 16x, with rollover to FY20e and TP at Rs 2,844
Tata Consultancy Services’ (TCS’) Q3FY18 revenue, at $4,787 mn (up 1.0% q-o-q) and Ebit margin at 25.2% were broadly in line with Street’s estimate. Key highlights: (i) BFSI declined by 1.5% q-o-q on softness in North America; (ii) retail turned around with growth of 6.4% q-o-q; (iii) digital revenues grew 13.9% q-o-q/39.6% y-o-y, representing 22.1% of total revenues; and (iv) traditional retailers are leveraging technologies to enhance value proposition to customers, implying an optimistic outlook. We believe that digital at 22.1% (growth of 33.9% y-o-y YTD), both US and Europe showing strong traction and current margins (25.2%) below the aspired 26-28% range indicate that things can only improve from here. Hence, we raise our target multiple to 18x from 16x earlier, and roll forward to FY20E. Maintain Hold with target price of Rs 2,844 (18x FY20e EPS).
BFSI dampens an otherwise good performance
TCS reported 1.3% q-o-q CC revenue growth led by modest growth across verticals, excluding BFSI, which declined 1.5% q-o-q. The commentary on BFSI remained cautious (though only for North America region). Energy and utilities although small (4.5%) posted a robust 8.5% q-o-q and 29.4% y-o-y growth, implying bottom of capex spending in this segment as well.
Digital grows stronger, retail turning around
Digital (22.1% of revenues) was up 39.6% y-o-y, on increasing deal sizes as digital penetrates deeper in clients’ businesses. Management also highlighted trend of customers moving from small to large vendors in their transformation journey. Further improvement in retail is expected as traditional players leverage digital technologies to enhance customers’ value proposition.
Outlook and valuations: Digital to steer growth; maintain ‘HOLD’
TCS reported in-line numbers. A few key positives include: (i) growth rate has bottomed out at 5-6% as digital is growing at robust rates and accounts for a substantial 22.1% of revenues; (ii) margins declined from 30% in FY14 to 25%, limiting further downside (ex-currency); (iii) retail has revived and BFSI may do well with recovery in the US; and (iv) high cash generation with 80% distribution, implying high dividend yield. Factoring in these positives, we raise our target multiple to 18x from 16x earlier, and rolling over to FY20E we peg our TP at Rs 2,844. However, due to mere 1.9% upside from current levels, we maintain ‘HOLD/SP’ recommendation/rating on the stock.
Increasing digital proportion implies bottom of revenue growth
Digital now accounts for 22.1% of total revenue, versus 16.8% a year back. On YTD basis, revenue expanded by 33.9% y-o-y in FY18. TCS is witnessing constant increase in the size of digital transformation deals on account of deepening digital services in clients’ businesses. The company signed its first $50-mn plus digital transformation deal during the quarter. With base of digital revenues continuously seeing an uptrend, we believe digital could drive
4-5% revenue growth going forward even post rationalising digital growth rates to 20-25% y-o-y. Accordingly, we believe overall revenue growth rates should increase gradually going forward.
Margins to expand (ex-currency) on revenue acceleration
Margins for the quarter stood at 25.2%, much below the aspired range of 26-28%. Margins have contracted by 500bps since FY14 hampered by several headwinds. With majority of the headwinds now behind it and revenue growth expected to bottom out, we believe margins do not have further downside risks. Riding TCS’ excellent execution skills and with various cost rationalisation measures in play, we foresee gradual improvement in margins along with revenue acceleration.
Cash distribution to remain high
Historically, TCS has distributed 80% of its free cash-flows to its shareholders either by way of dividend or share buybacks. The company’s cash-flow generation is expected to remain high going forward due to limited scope for big acquisitions. Accordingly, we believe it will maintain, if not, increase its cash distribution to shareholders.
As India’s largest and most-experienced IT services firm, TCS is well-positioned to benefit from the growing demand for offshore IT services. It is a serious contender for winning large deals (company revealed last Tuesday it has signed a $690-million deal with M&G Prudential, the UK and European savings and investments business of Prudential plc.) , as it has more experience than peers in implementing large, complex, and mission-critical projects. End-to-end full services offerings, traction in emerging markets, ability to roll-up large acquisitions, improving sales and marketing prowess and willingness to take multiple big bets are among the key rationales for TCS to sustain its long term hi-growth trajectory.