TCS Ltd (Q1 FY15)

• Robust start to FY15 as expected; volume growth at 5.7% qoq

• Growth was broad-based across verticals and geographies; client mining remained impressive 

• Operating margin performance was resilient; but reclaiming FY14 margin will be challenging 

• PAT came in 8% higher than estimate despite one-off depreciation charge 

• Premium valuation caps material upside; downgrade rating from Buy to Accumulate

TCS delivered a better-than-expected constant currency dollar revenue growth of 4.8% qoq. After being modest in H2 FY14, volume growth revived sharply to 5.7% qoq as the company entered a seasonally strong period. Sustained downtick in pricing largely on account of services mix change impacted sequential growth by more than 1%. Marginal onsite effort shift and beneficial cross currency movements aided growth by 80-90bps. On balance, the reported dollar revenue growth stood at 5.5% representing revenue addition of US$191mn over previous quarter (highest in the past 15 quarters). Management expects growth momentum to sustain based on current sizeable order book, robust deal pipeline and company’s unflinching ability to execute. During Q1 FY15, TCS won seven large deals (nine in Q4 FY14). We estimate company to deliver industry-beating 18% dollar revenue CAGR over FY14-16. 

Revenue growth was broad-based across verticals; except for BFSI (2.5% qoq), all other verticals grew ahead of the company. Regionally, growth was led by US (5.5% qoq), Apac (8% qoq) and India (6% qoq). Amongst service offerings, infrastructure services (10.7% qoq), enterprise solutions (7% qoq) and assurance (8% qoq) grew at robust pace. Client mining was impressive with company adding 8 customers in US$20mn+ bucket and 5 clients in US$50mn+ bucket. 

TCS’s OPM contracted by lower-than-anticipated 208bps qoq to 28.8% aided by a material 150bps improvement in employee utilization levels. Utilization without trainees reached an all-time high of 85.3% driven by robust volume growth and focus on productivity. With company adding net 1.7% to its employee base during Q1 FY15, utilization levels in the near-term are expected to remain elevated as brisk execution is likely to continue. During the quarter, there were multiple headwinds in the form of wage hikes (impacted margin by 220bps), rupee appreciation (impacted margin by 73bps) and onsite revenue shift. LTM attrition remains much lower than industry at 12%; above-average salary hikes, regular promotions and strong growth delivery is keeping attrition under check. Though TCS has operational levers such as offshore shift and squeezing productivity gains from fixed price contracts (the share of which has risen over the past two years), sustaining operating margin above 30% in the longer term would be difficult as utilization is bound to normalize somewhat.

PAT came in higher than estimate despite one-off depreciation charge 

Aided by stronger-than-expected revenue growth, resilient margin performance and higher other income (forex tailwind), TCS’s profit for Q1 FY15 stood 8% higher than our estimate. This was despite a one-time depreciation charge of US$29mn due to change in useful life of assets from the start of the year. As we believe that it would be difficult for the company to deliver operating margin above 30% in FY15/16, we forecast a revenue lagging earnings growth of 15% pa over the period. 

Premium valuation caps material upside; downgrade rating from Buy to Accumulate

Trading currently at 18.5x FY16 P/E, TCS’s valuation is at 30-40% premium to peers. While robust growth delivery/visibility and strong margin resilience justify higher valuation, we believe that room for further absolute or relative re-rating is limited unless company surprises on growth in H2 FY15. Recent rally in the stock limits scope for any significant incremental upside in the medium term. We therefore downgrade our rating on TCS from Buy to Accumulate.