Probably, for the first time in recent memory, the expectations surrounding the TCS fourth quarter results were at an all-time low. Markets were extremely sceptical about TCS Q4 performance in terms of profit growth as well as in terms of margins. It is in this backdrop that the results were announced for the fourth quarter ending March 2017.
Growth in revenues and profits.
The March 2017 quarter actually marks the 10th successive quarter when TCS has reported slower growth. The slide in growth is actually quite steep. For example, the revenue growth in constant currency terms has fallen from 12.2% in Q4-2015 to a level of 7.5% in Q4-2017. That slowdown in revenue growth has been a clear outcome of the slowdown in the growth in tech spending, especially in the BFSI (Banking, Financial Services and Insurance) space. In fact, BFSI which accounts for over 40% of the revenues of TCS was almost flat for the quarter. The operating margins of TCS have fallen below its comfort zone of 26-28% for the first time and that could be worry for TCS.
On a quarter-on-quarter basis, TCS did show growth traction in top-line and bottom-line. For the fourth quarter, TCS reported 4.2% higher revenues at Rs.29,642 crore and a 4.2% growth in net profits at Rs.6608 crore. Revenues and profits did come under pressure on a sequential basis. However, the operating profits did fall by 1.4%, which is symbolic of cost pressures on the company.
Digital could be the redeeming factor for TCS.
The big boost for TCS comes from its digital business. For the full year 2016-17, digital business has generated revenues of $3 billion, which is 17.9% of its overall revenues. Both in absolute and in percentage terms, TCS now has the biggest exposure to digital compared to other large technology companies. What is also gratifying is that the digital business has growth on a YOY basis by 29% and promises to sustain this rate of growth in the years to come. TCS derives a chunk of its digital revenues from cloud automation, analytics and IOT (Internet of Things).
The question is why is the digital business so critical? Firstly, digital is the business where most of the fresh IT investments are coming. As companies are increasingly looking to transform their businesses through digital adoption, this business could get a big leg up. Secondly, the IT industry is rapidly shifting from a model dominated by BFSI (Banking, Financial Services and Insurance) to a model dominated by SMAC (Social Media, Mobility, Analytics and Cloud). Lastly, a healthy growth in digital business is essential to de-risk the IT business model. That is exactly where TCS scores very high.
Capital Allocation and how it will impact stock prices.
The company has traditionally been conservative on dividends and continues to hold its dividend yield at under 1.5%. The company has already announced a buyback of shares to the tune of Rs.16,000 crore. However, that is unlikely to excite the stock substantially as traditionally buybacks have rarely added value to the stock over the long term. That is because what the company benefits in the form of higher EPS due to lower number of shares outstanding tends to get compensated by lower P/E ratio. As a result, from a valuation point of view it will be better if the capital distribution policy is kept as conservative as possible. It will be seen as an indication that there are still growth opportunities in the business. On the contrary, Infosys announcing a $2 billion payout, despite being half the size of TCS, is being interpreted by the markets as a signal that future growth prospects are limited. That does not go down well with institutional investors.
How to evaluate the investment potential of TCS after Q4 results.
There are a few key takeaways from the Q4 TCS results. Firstly, the pressure on top-line and bottom-line growth is quite evident. While that can be partially blamed on the size effect, it has also to do with the fact that traditional IT spending is seeing pressure. Secondly, the operating margins have come down marginally by around 100 basis points and that is more due to high manpower costs and pressure on end-customer pricing. On a rolling basis, the stock of TCS is available at around 15 times earnings and when you look forward to the next 2 years it could be quoting at an exciting 12.5 times earnings. Here are the key takeaways for TCS to sustain investor interest in the stock.
There has to be a major focus on automation so as to reduce the manpower cost and improve margins. With its current rate of manpower accretion, it will be difficult for TCS to show growth and margins on a consistent basis.
TCS will have to continue to look at digital as its big focus area and increase the share of digital at the cost of the BFSI market share. That will help TCS to reduce manpower and also improve margins in the business. That could hold the key to the future of TCS.