TCS well-positioned to withstand weakening macro environment? Here’s what top brokerage firms say

The annual report of Tata Consultancy Services (TCS) for the financial year 2022-23 highlighted the company stood strong in the last financial year despite challenging times due to the weakening macro environment. Analysts and brokerage firms believe the IT behemoth is well-positioned to withstand the pressure going ahead.

Brokerage firm Motilal Oswal Finacial Services is positive about the IT major given its size, order book and exposure to long-duration orders and portfolio. The brokerage firm has a 'buy' call on the stock with a target price of ₹3,860, implying a 20 per cent upside potential in the stock and 25 times FY25E earnings per share (EPS).

TCS stock, along with its sectoral index BSE IT, has disappointed investors in the last one year. While the equity barometer Sensex is up 13 per cent, TCS is down 4 per cent and the BSE IT index is down 5 per cent in the last one year. The stock has underperformed the benchmark index even in the short term. In the last three months, TCS stock has fallen 4 per cent and the BSE IT index is down 3 per cent while the Sensex is up 5 per cent in that period.

The road ahead may be bumpy if decision-making and conservation of cash continue from clients. However, emerging trends in some areas cush as cloud transformation and rapidly growing penetration of AI (artificial intelligence) offer some hope.

Highlighting TCS' annual report for FY23 (AR23), Motilal Oswal said that the analysis of TCS AR23 not only shows the widespread adoption of digital technologies in customer-facing operations but also the increasing penetration of AI and automation in middle and back-office operations.

Apart from the demand for driving operational efficiency and optimising costs, cloud transformation remained a high-priority area for enterprises in FY23, Motilal said.

Despite demonstrating strong resilience, TCS anticipates the possibility of moderate full-year revenue growth in FY24 if instances of delayed decision-making and cash conservation from clients reoccur, the brokerage firm added.

As Motilal Oswal pointed out, TCS reported constant currency (CC) revenue growth of 13.7 per cent year-on-year (YoY) in FY23, led by retail and consumer and communications segments (up 19.7 per cent YoY and 14 per cent YoY).

"Despite the challenging demand for banking in the second half of FY23, the BFSI (nearly 32 per cent of revenues) vertical grew in double-digits (up 11.8 per cent YoY CC) in FY23. North America and the UK which collectively contribute 70 per cent to the company’s revenues, exceeded consolidated level growth. It grew 15.3 per cent and 15 per cent YoY CC, respectively," Motilal Oswal observed.

Moreover, TCS was unable to recover the intensity of the wage hike through the year, Motilal Oswal pointed out, which led to a 120-bp YoY decline in the margin at 24.1 per cent. This was majorly attributed to backfilling and retention expenses (accounted for 140 bps drag), which were partly offset by cost optimisation and the Indian rupee depreciation, said the brokerage firm.

On a segmental basis, major margin dilution has come from the manufacturing segment at 27.5 per cent (down 260 bps YoY). This was followed by retail and life science, which were down 200 bps YoY each, at 25.7 per cent and 28 per cent, respectively. The subcontracting expenses as a percentage of revenue stood at 9.2 per cent (up 40 bps YoY). The uptick is partly attributed to the elevated attrition (at 20.1 per cent), leading to a higher dependency on outsourcing for immediate execution, Motilal Oswal added.

"The company has identified several margin levers that are expected to come into effect in FY24: (1) reduction in subcontracting expenses (2) improvement in utilisation (3) pyramid rationalisation, and (4) currency support," said the brokerage firm.

TCS' cash conversion remained strong; while pre-tax OCF/EBITDA (operating cash flow/earnings before interest, taxes, depreciation, and amortisation) came in at 94.5 per cent, FCF/PAT (free cash flow/profit after tax) stood at 92.2 per cent. The company generated ROE (return on equity) and ROCE (return on capital employed) of 47 per cent and 41 per cent in FY23 versus 44 per cent and 37 per cent in FY22. Net cash and cash equivalent stood at ₹47,500 crore, translating to 4.1 per cent of the market cap, Motilal Oswal observed.

On the front of operating metrics, TCS saw a net addition of over 22,000 employees while the gross hiring of freshers stood at 44,000 in FY23. TCS exited FY23 with an overall deal total contract value of $34.1 billion, Motilal Observed.

“Given TCS’s size, order book and exposure to long-duration orders and portfolio, it is well positioned to withstand the weakening macro environment and ride on the anticipated industry growth. Owing to its steadfast market leadership position and best-in-class execution, the company has been able to maintain its industry-leading margin and demonstrate superior return ratios,” Motilal Oswal said.

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Brokerage firm Kotak Institutional Equities has an 'add' call on TCS stock with a target price of ₹3,320.

"TCS is well-positioned to benefit from clients' cloud migration journeys. The slowdown in discretionary spending will hurt, but the impact will be partially offset through participation in vendor consolidation and cost take-out-based large/mega-deals, where TCS will take a prudent approach to margins," said Kotak Securities.

Kotak underscored that TCS has a balanced portfolio of services between run and change budgets, in line with clients’ IT budgets.

"It has good capabilities in both discretionary and cost take-out programs and can cater to both spectrums of demand. The company is well-positioned to benefit from higher emphasis on cost take-outs and focus of enterprises on complex transformations involving operating model change and core modernisation," Kotak said.

However, the brokerage firm added the company is not immune to a weak discretionary demand environment and uncertainty/delays in decision-making.

The brokerage firm pointed out that the stock price has barely corrected in the last 3-4 months despite the deterioration in the demand environment while continuing to trade at premium multiples. As a result, further upside from current levels can be limited to an extent unless the demand environment changes (better discretionary demand or greater focus on cost take-outs leading to more large/mega deals).

Disclaimer: The views and recommendations given in this article are those of the brokerage firms. These do not represent the views of Mint. We advise investors to check with certified experts before taking any investment decisions.