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  • Stock Recommendation | TCS - REDUCE - Target price : Rs 1,950

    Publish date: OCTOBER 12, 2018

    Good performance, stock price not supportive. TCS reported excellent 3.7% qoq and 11.5% yoy c/c revenue growth and rupee depreciation-led margin expansion. Revival in growth of key verticals and benefit of mega deals signed at the beginning of the year will power 10.7% c/c revenue growth in FY2019E. Double-digit growth requires consistent flow of mega deals and a strong macro, both of which are not certainties. Stock valuations already imply consistent double-digit growth, an aggressive assumption, leaving nothing on the table. REDUCE stays; EPS estimates and TP remain largely unchanged.

    TCS delivered 3.7% qoq and 11.5% yoy revenue growth in c/c. The revenue growth was led by financial services (+3.5%), retail & CPG (+3.4%) and regional markets (+7.3%). Digital revenues grew strong at 16.5% qoq and 59.8% yoy and now constitute 28.1% of revenues; investments by clients in building up of digital core, which is a larger opportunity, are contributing to the acceleration. EBIT margin increased 140 bps qoq with 30 bps increase attributed to operations and the balance to rupee depreciation. Gross margin barely increased on yoy comparison with the entire margin increase attributable to SG&A leverage (partly due to decline in bench cost). Net profit of ₹79 bn (+22.6% yoy) missed our estimate and was impacted by lower-thanexpected other income (₹950 mn Fx loss and ₹1.37 bn of finance cost).
    Management commentary on demand was largely positive. TCS expects banking demand improvement to be structural in nature. North America is improving and the growth is broadbased in nature. Healthcare and energy & utilities demand is strong. The management reiterated its confidence of double-digit revenue growth in FY2019E. However, there are a few rough edges that require close monitoring-retail growth is strong but the segment itself is not structurally out of the woods, technology and communication verticals are volatile and automotive sub-vertical within manufacturing has slowed.
    Undoubtedly TCS will have a remarkable FY2019 led by-(1) ramp-up from mega deals signed in 2HFY18, (2) faster-than-expected recovery in financial services and (3) the industrialization phase of digital. The company will grow in FY2019 by 10.7%. Currency depreciation has helped margins rebound strongly to 26.5% from 24.8% in FY2018. However, the stock faces the test on the following counts-(1) mega deal ramp-up and recovery across verticals were required for a double-digit growth, something that may not recur as a combination in FY2020E. The stock price already embeds a strong growth trajectory beyond FY2019E, (2) the ability to retain currency gains when the rupee stabilizes and (3) rich multiples. Even as we like business model strengths of TCS, the stock price is not attractive. We broadly retain our estimates; target price of ₹1,950 remains unchanged, valuing the stock at ~20X September 2020E earnings.
    Our FY2019E and FY2020E estimates are based on INR/USD rate of 70 and 72, respectively.
    TCS’ strength of business model and global leadership in multiple facets make it a compelling stock. However, stock investment requires closer scrutiny of three aspects-
    Sustenance of growth after adjusting for large deals
    FY2019E will be a strong year for TCS led by recovery in retail and banking verticals and benefits of ramp-up of mega deals. We estimate close to 3% contribution from large deals to FY2019 constant currency revenue growth rate of 10.7%. TCS signed five mega deals with cumulative TCV of US$8.8 bn and can contribute US$550 mn incrementally in FY2019E. Specifically we highlight-(1) large multi-year contract with Marks and Spencer that establishes TCS as the principal technology partner, (2) US$2.3 bn renewal of outsourcing contract with AC Nielsen that contains a small portion of incremental revenues, (3) US$2 bn+ contract with Transamerica that enhances digital capabilities and simplifies servicing of 10 mn+ policies into a single integrated platform, (4) the Scottish Widows deal that runs over 15 years and involves end-to-end policy administration services and (5) 10-year deal with M&G Prudential valued at US$690 mn. The partnership was extended further by an additional US$668 mn, bringing the total number of policies administered to 5.8 mn and deal size to US$1,358 mn
    The important question is whether the growth delivered in FY2019E will repeat in FY2020E. In support of the growth argument is TCS’ capabilities to structure such deals. Full-blown recovery in the banking vertical in FY2020E will also aid performance. Against such an argument is that closure of these mega deals is unusual and that the timing of deal closures in a short 2HFY18 was fortuitous and unlikely to sustain. Further in a world of constant disruption, expecting all verticals to fire at the same time can be a stretch.
    Reinvestment of currency gains
    Currency is a big facilitator for margin in the near term. TCS’ EBIT margin will increase to 26.5% in FY2019, up from 24.8% in FY2018. Whether the company and the industry can retain the currency benefits is a moot point. Past experience does not suggest so.
    Valuation-stock demand high absolute revenue addition
    TCS will add US$2.04 bn of absolute incremental revenue in FY2019 in constant currency terms. To justify the current price (assuming CoE of 11%), TCS needs to add US$2.24 bn of absolute revenues in FY2020E followed by 10% CAGR in incremental revenues for a period of eight years. To sustain the growth will not be easy. To put the absolute revenue addition hurdle in context, Accenture-the closest competition of TCS, has added US$1.6-2.7 bn of revenues on organic in its best years of FY2016-18.
    TCS requires a mix of strong demand across verticals and mega deals to support the current valuations and generate 11% annual return (COE). In effect, TCS stock embeds double-digit revenue growth, retention of margin benefit and sustenance of P/E multiple to generate 11% return, a stretch. Punchy valuations and lack of margin of safety is to a large extent the reason for our cautious stance. However, such an analysis is fraught with one big risk- rupee depreciation. Currency depreciation brings down the hurdle growth rate quite a bit.
    Digital growth accelerates
    Digital revenues grew 16.5% qoq and 59.8% yoy in c/c terms and now constitute 28.1% of revenues. Investments by clients in building up of digital core, which is a larger opportunity, are contributing to the acceleration. TCS broad-suite of competencies and investments helps in capturing this large spends. Industry analysts consistently recognize TCS as a leader in digital.

    Margin walk-through. EBIT margin increased 150 bps sequentially to 26.5% in 2QFY19 resulting from (1) 120 bps tailwind from rupee depreciation against the US dollar and (2) 30 bps tailwind from operational efficiencies.
    Revenue growth outlook. Management is confident of reaching double-digit growth in revenues in FY2019. Strong order book and deal pipeline give good visibility in the medium term.
    Commentary on new service delivery models. (1) Agile delivery model-TCS has repositioned the agile model as a fast and reliable way to deliver business transformation at scale. TCS is heavily investing in its location-independent agile model and has seen good traction from clients. The company aims to become 100% enterprise agile by 2020. 280,000 employees have been trained in agile methods. Delivery surfaces and controls have been reworked to support agile engagement. TCS has started using an agile maturity framework to assess its agile engagements and plans to increase the maturity of its agile engagements. (2) Machine first delivery model-TCS’ automation-led machine first delivery model goes beyond providing productivity benefits to clients. It changes work processes to enable growth and transformation with customer experience and quality at the core.
    Deal wins. TCS won US$4.9 bn TCV of deals in the quarter and flat on a sequential basis. US$1.6 bn TCV of deal wins are in the BFSI vertical while US$700 mn TCV of deal wins are in retail vertical. North America contributed US$2.4 bn TCV of deal wins.
    Client metrics. # of US$100 mn clients increased by four on sequential and seven on yoy comparison. The company reported healthy increase in number of US$20 mn clients.
    BFSI vertical outlook. Growth in the vertical is broad-based across geographies and between banking and insurance. Management clarified that revenues under the BFSI vertical represent revenues from BFSI services while platform revenues are reported under regional markets & others vertical. Demand is driven by investments in cloud migration, micro-services, cyber security and intelligent automation. Wealth management and commercial banking practices have seen acceleration in digital investments.
    Retail vertical outlook. Technology investments are driven mainly by traditional retail companies increasing their digital investments to compete with e-commerce companies. Management cautioned that despite healthy growth of retail revenues, headwinds continue to exist in the vertical.
    Commentary on auto sector. Softness in the auto sector is due to technology changes, which have forced auto OEMs to invest more in connected vehicles and electric car projects, leading to squeeze in traditional spends.
    Commentary on US geography. Spends in the vertical have improved structurally due to a milder regulatory environment resulting in spends towards digital transformation. Reduction in corporate taxes has aided spending by companies.
    Commentary on UK geography. Platform deals, large retail deals and strong growth in BFS services segment are contributing to strong growth in UK revenues. Convergence to global sourcing models, investments to catch up with technological changes and leapfrogging technology investments are key drivers of growth in the geography.
    Hiring. TCS added 10,227 employees on a net basis during the quarter, taking its total headcount to 411,102. TCS is using programming contests and Hackathons for identifying and hiring talent. TCS conducted TCS National Qualifier Test in the quarter. This provides an alternative to hiring from campuses and provides access to a wider talent pool and reduces lead time in the hiring process.
    Hedging policy. Management reported no changes to its hedging policy in light of recent rupee depreciation. TCS’ hedging strategy takes a long-term view of currency movements and essentially smoothens the effect of currency volatility at the net profit level.
    Capital allocation. TCS completed ₹160 bn buyback of equity shares during the quarter. TCS board has recommended an interim dividend of ₹4/share.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
    NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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