Second quarter results: Why Infosys wins this bout against TCS

In the recent quarterly earnings show, Indian tech bellwethers TCS and Infosys put in contrasting performances. While TCS disappointed investors, its rival quietly stole a march over it. Infosys seems to be kicking into higher gear at a time its larger peer is slowing. Is a shift in growth underway?

Here is how the two index heavyweights fared in the September quarter. TCS missed revenue estimates, with dollar sales growing at just 1.6% compared to the previous quarter. This was the weakest second quarter growth since September 2017, despite being the seasonally strongest quarter. Meanwhile, Infosys revenues grew 2.5%, in line with Street estimates. In constant currency terms, revenues at TCS and Infosys grew at 8.6% and 11.4% y-o-y, respectively. Revenue growth at Infosys was broad-based, with five verticals delivering double-digit growth. TCS reported weakness in several core verticals.

Profit margins at TCS shrunk to a nine-quarter low even as Infosys’s margins expanded for the first time in five quarters. Infosys margins were aided by improving utilisation, lower onsite mix, apart from absence of visa expenses. However, the Infosys profit margin at 21.7% continues to be lower than that of TCS at 24%. This is the second successive quarter that TCS has missed revenue and margin estimates.

Interestingly, with a bigger share of digital services in its revenue, Infosys registered higher growth in the segment than TCS. While TCS registered deceleration in digital growth at 28% y-o-y, Infosys clocked 38% growth in this space. Even after adjusting for acquisition of Stater, the digital growth of Infosys is higher. This is critical as margins in digital services are higher than in legacy contracts.

Infosys reported the biggest-ever quarterly deal wins, with 13 large deals worth $2.8 billion. Almost 90% of the new deals were renewals, not incremental client additions. TCS scored big on this front, clocking $6 billion worth of deals. However, analysts are sceptical about the prospects of TCS in coming years, for multiple reasons. “The September 2019 quarter confirms the risks to the company’s earlier suggested outlook of double digit growth. While the stock has been weak in the run up to results, we see a case for more downsides in the near term,” contend analysts at Emkay.



Given the sticky growth outlook and its rich valuations, there is a case for multiple derating in TCS, says Harit Shah, Analyst, Reliance Securities. “In such an environment, double-digit growth is a mirage and growth expectations must be watered down, particularly in context of slowing digital growth.” HDFC Securities downgraded TCS to ‘Neutral’ (from ‘Buy’ earlier) and struck it off its list of conviction picks following nearly 4% EPS cut and a weak growth trajectory. “TCS’ trinity of growth, scale and durability is challenged and we find our conviction displaced,” say analysts at HDFC Securities.

Given the apparent struggles at TCS and resurgence in Infosys, analysts are more sanguine about the latter’s prospects. “The company’s performance is reassuring, especially given the disappointment at TCS, and keeps the hope alive for margin improvement through the rest of 2019-20,” say Emkay analysts.

Over the past few months, Infosys valuations have been closing the gap with TCS. Infosys is currently trading at 8% discount to its peer, down from 40% discount last year. This may narrow further. “As Infosys is delivering strong performance on both revenue and margin, we believe the discount to TCS would further narrow down going ahead,” says brokerage firm Sharekhan in a note.

However, the relative performance of the two IT majors cannot be viewed in isolation. It has to be viewed from the context of the broader sector growth. The IT sector as a whole was exhibiting a growth rebound in the past three years, supported by cyclical recovery in IT spending and aided by corporate tax cuts in the US. However, growth has again moderated in recent quarters owing to a global slowdown and trade issues.

This puts Tier-I IT firms in a better position as they can withstand headwinds. “We believe that volatile macro is a risk to near-term financial performance, although the emerging shift toward greater offshoring and scaling up of digital spends should work in favour of Tier-I techs,” say analysts at Emkay. Analysts at Prabhudas Lilladher continue to prefer IT companies where the expectations are lower, possibility of growth guidance is higher and dependence on external demand is lower, coupled with valuation comfort.