TCS - Analyst Meet Update - Angel Broking

Tata Consultancy Services (TCS) hosted an analyst briefing. Following are the key takeaways:

Strong demand environment, broadcasted growth: TCS' Management indicated that the overall demand remains good and in line with its expectations, and that 1HFY2014 should see positive seasonal tailwinds. While core markets (the US and Europe) are tracking overall trends, emerging markets would remain lumpy. In the US geography, the Management indicated that growth is more broad-based. Demand is predominantly from existing customers on new technology and new IT spends. The projects are smaller in size, but clients are taking decisions around discretionary IT spending as well. Growth is likely to be dominated by market penetration in the European geography and new client addition. The deals are more of large total outsourcing deals, a trend witnessed by Indian IT vendors in the early part of last decade. As far as emerging markets are concerned, India continues to be volatile.

Growth is likely to be robust across industry verticals barring telecom, which as per the Management, is going through structural difficulties. However, recent deal wins in this space will assist revenue growth. Growth is expected to be strong across service lines, especially in discretionary services. TCS indicated that discretionary spending was improving in the US across verticals with clients spending more on revamping their front-end systems.

2Q growth to be strong: For 2QFY2014, the Management indicated that USD revenue growth is expected to be strong as suggested at the beginning of the year. Seasonality for the full year is playing as expected (2Q is the strongest quarter seasonally for Indian IT companies), with growth in 1H expected to be stronger than that in the second half of the financial year FY2014. Pricing is expected to remain stable and growth is expected to be driven by volumes in the quarter. We model in a USD revenue growth of 5.0% qoq for 2QFY2014, taking into account the negative cross currency impact. Full quarter revenue from ALTI (the recent acquisition done by TCS), expected at ~EUR30mn, will compound growth during the quarter (will contribute ~1.1% to growth).

Operating margin expected to increase sharply: In the current quarter, TCS' operating margin has faced marginal headwinds from promotion-linked impacts and integration of ALTI whose margins are lower. However, excluding the impact of currency fluctuation, the company expects margins to be comparable to that in the last quarter, aided by healthy revenue growth. Depreciation in INR is expected to provide a margin tailwind benefit of ~275-350bp qoq. We are currently modeling in a qoq EBIT margin expansion of 280bp to 29.9% for 2QFY2014.

Forex losses on hedge positions: TCS' Management indicated that during 2QFY2014, the company is expected to incur forex losses to the tune of Rs. 550-650cr, largely on account of range forward options, assuming Re/USD range of 65-68. It be noted that 50% of TCS' hedges are in the form of options, a fair portion of which could be range forward options.

The Management indicated that range forwards were used since they are cheaper. In addition, TCS will likely carry forward losses of between Rs. 300-700cr in the balance sheet and the same will flow into the P&L in the subsequent quarters. Our PAT estimate for the quarter stands at Rs. 4,560cr, up 20% qoq.

TCS to wait for stability before reinvestment of Rupee benefit: TCS will continue to seek opportunities to invest in emerging markets and service lines. The big issue is to move into the non-English speaking geographies. The domestic currency, at current levels, gives an additional degree of flexibility. The pace of Rupee depreciation has been so sharp that the company has not yet invested the Rupee gains in the near term. If the Rupee remains at current levels, TCS will reinvest the benefits into the business over the medium term. The Management indicated that it reinvested Rupee gains in the business in the past as opposed to offering discounts/passing on Rupee benefits to clients. Instead of passing the benefits to clients, the approach is more towards reinvesting in newer segments. Having said that, these are extreme situations, and so the Management will also keep a watch on competition.

Outlook and Valuation: We expect TCS to grow its USD revenues at a CAGR of 15% over FY2013-15 and EPS at a CAGR of 20% during this period. We believe TCS will continue to lead industry growth while maintaining its profitability. TCS has executed well over the past many quarters and currently trades at 21.6x FY2014E and 19.3x FY2015E EPS. After the sharp upmove YTD, we believe that TCS' valuations are rich and build in a relatively strong operational performance. Keeping that in notice, we maintain Neutral rating on the stock with target price being Rs. 2,065.

Source : Equity Bulls

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