See limited returns from TCS, prefer Infosys: Edelweiss

Tata Consultancy Services on Thursday reported a better-than-expected profit and operational performance in April-June quarter. While revenue was in-line, profit fell 0.36 percent sequentially to Rs 6,318 crore in Q1 but that was supported by better operational numbers.Sandip Agarwal, Edelweiss Financial Services thinks the constant currency growth of 3.1 percent will put pressure on the Q2 and it will be hard for them to grow at 10 percent organically for the fiscal.

However, the margins at 25 percent despite wage hikes were good. Fall in attrition levels aided margins and operational efficiencies. So margins were a surprise in Q1.

He expects limited returns on the stock price of TCS in the medium-term and prefers Infosys on back of margin levers and growth.Below is the verbatim transcript of Sandip Agarwal’s interview with Latha Venkatesh & Sonia Shenoy on CNBC-TV18. Sonia: Do you think Tata Consultancy Services (TCS) deserves to trade at such high valuations of 18 times FY18 based on the fact that there are risks to near-tern growth? A: I believe that it is not trading at 18 times; it is around 17 or slightly below that. In my view if you see how we see the result is, it is in two parts. First part is on the revenue side and the second part is on the margin side and third obviously is the global scenario. First of all coming to revenue front I think 3.1 percent constant currency puts a lot of pressure on quarter two because if you see historically quarter three and quarter four are slightly weaker for TCS. So, it is a first half driven company, what you achieve in first half that is going to decide the full year revenue growth. In my view with 3.1 percent it will be very hard to do 10 percent growth for the full year in constant currency organically. So, that is a challenge number one, from that perspective we are not very happy with the numbers. We expected them to do slightly better than that. On the margin front if you see in IT industry we very keenly track the attrition number. The attrition has sharply fallen. 12.5 percent IT services attrition is really a very good attrition numbers. It should generally help them improve their margins going forward as well. If you see in this quarter also as highlighted by the CFO there was benefit because of falling attrition in margins. Margin surprise has come primarily because of operational efficiency and also sharp fall in attrition. This is a very key parameter and we are very excited with the number on the attrition front. If you take both the things together one disappoint and one positive surprise and then you take into account what is going to happen, you have only one quarter to do everything that is quarter two to quarter three and quarter four seasonal weakness will pour in. So, basically in the whole scheme of thing and also taking in account we have uncertainty in terms of what happens post Brexit at least in the BFSI space and TCS and Infosys having very big exposure that is obviously a red flag there. We have to be very cautious on that. However, having said so we are also little worried about if you dissect the 3.1 percent growth a good part of growth has come from UK and Europe while we are indifferent to growth at least on the geographical parameters and we always focus on growth from the verticals and service lines. However, this time because of uncertainty on Brexit we are little worried that US has not done that great. If you take all this things in my view I would not be very optimistic with these numbers. Latha: What does that translate in terms of your price expectation? A: I will not be able to give any short-term reaction but in my view the returns will be limited in medium-term from the stock. We will continue to prefer Infosys which has much higher margin levers and much better growth drivers. However, assuming that all these will not have a significant impact of Brexit and if Brexit impact happens then it will impact the whole sector. Sonia: What are your earnings per share (EPS) estimates for FY17 and FY18 and how does that compare to Infosys now? A: We are expecting Rs 136 for FY17 and around Rs 150.50-151 for TCS. If you say the same number for Infosys, it is around Rs 67-68 and Rs 75-76, so that is the range but yes, we have not build in any significant change from the currency impact because we just had seven days of impact in June, so we have to wait for Infosys numbers and we may change after that. Latha: Do you expect TCS will be able to maintain 26 percent margin; 26-28 is their band but they have done an EBIT margin of 25.1 in the first quarter. A: In spite of wage hike 25.1 in Q1 is a good number. They have beaten our estimate by 70 bps. In Q2 there are no costs pressures so ideally their margins can go up significantly maybe 150 bps of further improvement can happen in Q2. Q3 and Q4 is also a question of how much growth comes but I do not think 26 percent will be a big challenge. I think they will end up at a lower band of the range. However, if the concerns of growth would not have been there then the sharp fall in attrition would have enabled them to reach the midpoint of the guidance.