TCS - Stretched Valuation Drives Downgrade - Nirmal Bang

We attended Tata Consultancy Services' (TCS) quarterly analyst meet. As per the information technology (IT) major, clients are taking decisions on IT budgets and contracts are getting cleared. TCS maintained its earlier commentary of 'front-ended growth' in FY13. The company remains in hiring mode, as 2QFY13 has seen project ramp-ups, which could lead to an onsite shift. This, in turn, could exert pressure on margins. Re-investment - in contracts like Friends Life for example, where upfront costs are incurred - is likely to lead to TCS not achieving full benefits from rupee depreciation. Regards verticals, retail, insurance, manufacturing and hi-tech are witnessing good traction. From a service line perspective, growth is likely to be broad-based, while geographically North America, the UK and continental Europe are registering consistent growth. TCS has not witnessed instances of irrational pricing. We cut our 2QFY13 volume growth estimate to 3.2% QoQ (4.7%) and, in light of the run-up post results, downgrade the stock to Hold (from Buy) with a revised target price of Rs1,415 (Rs1,444) owing to a 2% cut in FY14E EPS.

Status quo on demand, onsite ramp-up seen in 2QFY13: TCS has maintained its earlier stance of 'front-ended growth' for FY13, as clients continue to make IT budget decisions and clear contracts. At this point, despite a volatile global environment, it appears to be 'business as usual' and the deal pipeline has stayed consistent for TCS. The IT major has alluded to some deal ramp-ups in 2QFY13, which is likely to lead to an onsite shift and some pressure on margins during the quarter, given higher costs typically associated with onsite delivery. Hiring remains on track and TCS has no plans to delay the joining dates for campus hires.

Rupee weakness enables re-investment, newer contracts; not to realise full benefits: A weak rupee, given its benefits to the margin and cash flow profile, has enabled TCS to take newer contracts like Friends Life, which has upfront costs attached to it. The IT major has also re-invested some benefits into its business and has funded investments in new geographies, which operate at lower margins. This is the reason why the company is not likely to fully realise the benefits of a weak rupee at the margin level and its desired target of 27% EBIT margin is unlikely to be significantly surpassed, even though the 27% target is assuming US dollar-rupee rate of Rs48/$ and the Indian unit is currently at around Rs54/$.

Vertical, service line comments in line with earlier stance: TCS is seeing good traction in the retail, insurance, manufacturing and hi-tech verticals, even as the view on telecom remains cautious. From a service line perspective, growth is likely to be broad-based, adjusting for the one-off impact of the Friends Life deal on the BPO segment in 1QFY13. This is in line with the IT major's earlier stance also. Geographically, North America, the UK and continental Europe are largely witnessing consistent growth.

No irrational pricing: TCS has not come across instances of irrational pricing, even as the competitive environment remains challenging and concerns emerge about vendors passing on the benefits of a weak rupee in the form of price cuts in order to grab volume share.

Outlook and valuation: We cut our volume growth estimate for 2QFY13 to 3.2% QoQ (4.7%). Given the stock price run-up post results, we downgrade TCS to Hold (from Buy) with a revised TP of Rs1,415 (Rs1,444 earlier) owing to a 2% cut in FY14E EPS.

Source : Equity Bulls

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