Pains percolate to profitability
* Q1FY18 performance was better on revenue front, driven by strong volume growth of 3.5% qoq. The growth in focus geographies was encouraging across verticals with a cautiously optimistic approach towards Insurance and Retail.
* TCS is gaining significantly on competencies across Digital service offerings, leading to a sustained deal win traction, improved deal win ratios, and gain in deal sizes & complexity. Digital grew 7.6% qoq in CC terms and accounted for over 50% of incremental revenues.
* Focus shifted to profitability given the declining operating leverage, appreciating INR and compulsive commitments towards onsite hiring, digital skill training and sales with contextual expertise.
* We cut our FY18/19E EPS by 3%/4% to factor in lower profitability in our estimates. We continue to prefer players with growth acceleration such as Mphasis, Mindtree and L&T Infotech.
Profitability marred by lingering transitional woes
TCS has delivered a strong topline performance with 3.5% qoq volume growth, driven by sustained traction in the Digital service offerings. The management remains confident about improving competitiveness and capabilities of the company in the Digital business, and in general positive on traditional offerings in the focus markets/service lines. Despite strong volume growth, earnings declined by over 10% qoq on account of weaker currency realisations impacting revenues by 330bps and OPM by 80bps. Profitability was further affected by ~150bps owing to wage hikes (2-5% onsite and 5-8% for offshore workforce). We believe that the pain of deceleration in the legacy business, high-pricing-but-onsite-centric nature of Digital business, committed investments towards sales, skill and onsite hiring would percolate down to core profitability that has long been confined in a narrow band. To make things worse, the INR appreciation may also act as a headwind in FY18.
Cut FY18/19E EPS by 3/4% each; downgrade to Reduce TP Rs2,320
We cut our FY18/19E EPS estimates by 3%/4% to Rs136/145, as we incorporate lower INR realisations and also likely impact on profitability in our estimates (OPM cut of 50bps in FY18E). The outlook on the business growth has been largely kept intact in light of strong growth in Digital business and improved business metrics on the segment - size, scale, and competitiveness. Taking into account the risk to growth estimates and likely impact on profitability, we downgrade our rating on TCS to REDUCE with a TP of Rs2,320 based on 16x Mar’19E P/E (implied valuation of over 2x on PEG basis over FY17-20E).
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