TCS warning on spend raises concern over growth for IT sector

Stock price of TCS was down as much as 6.5% during intra-day trading

With Tata Consultancy Services (TCS), India's largest IT services provider, sounding the warning bells of a sequential loss of momentum as clients, especially in the banking and financial services segment, hold discretionary spends, it has yet again raised concern of a slowdown in the Indian IT sector.

TCS, in a filing to the BSE, said: "Based on the data at the end of August 2016, the company has characetrised 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."

The immediate impact of this was evident on the stock price of TCS, which was down as much as 6.5% during intra-day trading. The announcement by the company also pulled down the IT stock, with BSE IT index down 2.5%. Stock of Infosys, Wipro and Tech Mahindra were down 1.62%, 1.77% and 2.6% respectively at the close of trading hours.

For TCS, BFSI is its largest revenue contributor with 40.6% share and the US its majority market. The US contributed 53.3% of its revenue for the financial year 2016.

TCS is not the only one sounding the cautious outlook. Cognizant at the start of the CY had warned that it is seeing discretionary spends on hold by large banks. Infosys, a few week back, Infosys said that it will be able to give a clearer picture on its guidance only post second quarter results.

Both Cognizant and Infosys have cut their US dollar revenue guidance twice this year. Cognizant, has cut its revenue guidance for the second straight quarter, emphasizing the challenges impacting the IT industry. The company cut its full year (CY2016) revenue growth target to $13.47 billion to $13.6 billion representing a growth rate of 8.45% to 9.5%, one of the lowest ever for the company.

The management has said that guidance has been cut due to softness in discretionary spends in the banking finance services and healthcare, and a negative revenue impact of $40 million due to weakening of 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 revenues to grow between 10.5% and 12% in constant currency, as compared to the 11.5-13.5% 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 / 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 services player.

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

The near-term impact of this uncertainty, analyst expect is that the growth rate for FY17 will be subdued, considering 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% revenue growth in Q2FY17, it will require 1% 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, the firms first quarter margins were the lowest ever (25.1%). "We see downside risk to margin guidance of 26-28% after estimated H1FY17 average of about 25%. We estimate flattish margins in Q2 at 25% 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 analyst also believe that the valuation premium that TCS has over Infosys may also change with the former too sounding slowdown in BFSI. "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 favorable risk-reward for Infosys over a 12-month horizon given company's increasing investments in digital services and market share gain in traditional services," said BoAML report.