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TCS' profit warning spreads IT gloom

September 09, 2016 07:32 IST

Stock crashes 6.5%; top 5 firms lose Rs 33,883 crore in market cap

Concerns of slowdown in the Indian information technology sector came to the fore on Thursday when Tata Consultancy Services (TCS) said it was expecting a “sequential loss of momentum” as clients, especially in the banking, financial services and insurance (BFSI) segment, are putting discretionary spends on hold.

TCS, in a filing to the BSE, said: “Based on the data at the end of August 2016, the company has characterised customer outlook as one marked by ‘abundant caution’, with some holding back of discretionary spending - particularly BFSI vertical in the US - resulting in sequential loss of momentum.”

Slowdown fears
TCS says customers in BFSI holding back discretionary spending
In July, Infosys cut its annual revenue forecast by 100-150 basis points
Last week, Infosys said it would be able to give a clearer picture on its guidance only after second quarter results
Cognizant cut guidance, saying it sees softness in discretionary spends in banking, financial services and health care sectors

The immediate impact of this was evident on the stock price of TCS, which was down as much as 6.5 per cent during intra-day trading.

The announcement by the company also pulled down the IT stock, with BSE IT index down 2.5 per cent. Stocks of Infosys, Wipro and Tech Mahindra were down 1.62 per cent, 1.77 per cent and 2.6 per cent, respectively, at the close of trading hours. The top five IT firms - TCS, Infosys, Wipro, HCL Technologies and Tech Mahindra - lost Rs 33,883 crore in market capitalisation.

For TCS, BFSI is its largest revenue contributor with 40.6 per cent share and the US is its major market. The US contributed 53.3 per cent of the tech giant’s revenue in FY16. Notably, TCS’ insurance subsidiary Diligenta has witnessed slowing growth in recent times and the current caution will add pressure to the BFSI space as well.

TCS is not the only one sounding a cautious outlook. Cognizant, at the start of the calendar year, had warned that it was seeing holding back of discretionary spending by large banks. A few weeks ago, Infosys said it will be able to give a clearer picture on its guidance only post second quarter results.

Both Cognizant and Infosys have cut their dollar revenue guidance twice this year. Cognizant has cut its revenue guidance for the second straight quarter, emphasising the challenges impacting the IT industry.

The company cut its full year (CY16) revenue growth target to $13.47-13.6 billion, representing a growth rate of 8.45-9.5 per cent, one of its lowest ever. The management said the guidance was cut due to softness in discretionary spends in the banking, financial services and health care, and a negative revenue impact of $40 million due to weakening of the pound sterling due to Brexit.

Similarly, Infosys cut its annual revenue forecast at the top end by 150 basis points (bps, meaning 1.5 percentage points) and at the lower end by 100 bps.

The company said it is now expecting its revenue to grow between 10.5 per cent and 12 per cent in constant currency, as compared to 11.5-13.5 per cent it had given at the beginning of the financial year.

“Our checks and recent company commentaries suggest that Brexit is indeed creating near-term headwinds for IT services. As expected, the financial services sector is seeing bulk of the impact with smaller drag in the retail and travel verticals. Amongst the key financial services customers in Europe, UBS, Deutsche and RBS are expected to lower spend plans while Credit Suisse, Barclays, and Lloyds have not meaningfully altered spending,” said analyst at Bank of America Merrill Lynch in their note. All these banks are major clients for the Indian IT players.

Infosys had also announced the cancellation of contract with RBS, stating that this was an instance of cautiousness among key financial clients due to Brexit.

According to analysts, FY17 growth rate will be subdued, considering that the first half of the financial year is generally strong for growth.

“The US caution clearly reiterates our thesis that TCS, with huge dependence on H1, has very little margin of safety. Even if the company posts 3 per cent revenue growth in Q2FY17, it will require 1 per cent CQGR to clock even 8.5 per cet revenue growth in FY17. We continue to believe that even though TCS may post Q2 revenue growth in line with Infosys, its EPS growth will be lower due to extremely limited margin levers,” said Sandip Agarwal and Pranav Kshatriya of Edelweiss Securities in their note.

This will also mean added pressure on margins. “We see downside risk to margin guidance of 26-28 per cent after estimated H1FY17 average of 25 per cent. We estimate flattish margins in Q2 at 25 per cent as cross currency headwind and INR appreciation would be offset by normalisation of visa costs and partial absorption of wage hike,” said a note from IDFC Securities.

Many analysts also believe that the valuation premium that TCS stock has over Infosys may also change. “We expect the stock to be under pressure in the near-term on account of cautious commentary on demand environment particularly with regards to discretionary spending in a key vertical like BFSI. However, TCS with industry leadership and diversified presence is best placed to weather the near term macro challenges,” said the IDFC report.

“TCS trades at a high premium to Infosys, despite its higher exposure to financial services. Also, at 14.5 times FY18 P/E, we see a favourable risk-reward for Infosys over a 12-month horizon, given the company’s increasing investments in digital services and market share gain in traditional services,” said BoAML report.

“We reckon that now Q2 revenue growth will be only 1-2 per cent. Lower revenue growth and adverse exchange rate movements will likely also hurt profitability. As a result, there could be 3-4 per cent cut to consensus EPS estimates for FY17/FY18,” says Sagar Rastogi, technology analyst, Ambit Capital.

In Q1, the company posted 3.1 per cent sequential growth in its constant currency revenues. While he is positive on stock, TCS currently trades at 17 times FY17 estimated earnings. This is at a sharp premium to its peers though it is below its historical peak valuations of 20-21 times.

Photograph: Reuters

Shivani Shinde Nadhe & Sheetal Agarwal in Pune/Mumbai