May 01, 2017

Growth trend in TCS-Infosys verticals' annual EBIT margins

An analytical story I contributed recently to the media organisation I work for currently:

Segment dynamics weigh on TCS and Infosys margins growth

Over the last 4-5 quarters the stock market has accepted the grim reality of sluggish revenue growth in the information technology sector on the back of slowdown in business from banking and financial services clients as well as those from the retail and consumer major challenges and events.
There are also expectations of hi-tech and telecom business driving the growth engine of the software companies. Upsides from high end digital and next gen services offerings are expected by most analysts from the large software companies in the long term.
But how did past expectations play out last year. A fine reading of segment-wise margin numbers of the two largest Indian software companies, Infosys Ltd and Tata Consultancy Services Ltd, whose Jan-Mar quarter results are out, brings out interesting revelations.
Breaking down the segment-wise EBIT margin numbers shows Infosys and TCS getting better EBIT margins in 2016-17 from their manufacturing and retail verticals as compared to the previous year, according to an analysis of segment results data.
On the other hand, the EBIT margins fell in the verticals of banking and financial services, energy and utlities, communication and hi-tech for the two software majors.
The net impact was adverse since manufacturing and retail verticals had a 27% revenue share in both the companies while banking and financial services, energy and utilities, communication and hi-tech verticals together ha 57% revenue share each in Infosys and TCS.
Analysts have downgraded earnings growth for TCS since it delivered an earnings before interest and tax margin of 25.7% in 2016-17 (Apr-Mar) which was lower that the company’ stated EBIT margin guidance band of 26-28%.
Infosys' performance has invited similar reactions from the analyst community so far. Axis Capital said in its post-results research note that Infosys' margins performance in Jan-Mar and its lowered guidance for 2017-18 were below the brokerage firm's expectations.
The EBIT margin from the manufacturing vertical rose on year to 24.6% from 22.5% for Infosys, and to 28.6% from 26.8% for TCS, in 2016-17, an analysis of segment results data from Cogencis Corporate Fundamental Database showed. The earnings before interest and tax margin was considered as the operating margin in the analysis of the segment-wise financials.
Revenue from manufacturing clients accounted for 11% of total revenues for both the major software companies. The retail and consumer vertical also delivered better operating margins for Infosys and TCS in 2016-17 as compared to the previous year.
However, in terms of on-year revenue growth in 2016-17 this vertical, which contributed nearly 17% each to Infosys’ and TCS’s total revenue, saw growth fall more sharply as compared to 2015-16 compared to most other verticals.
Traditional retailers in developed markets, the main clients for the large Indian software companies, have undergone challenging times in the last one year.
Deceleration in retail and consumer vertical weighted on overall growth for 2016-17 for TCS, said Prabhudas Lilladher brokerage in its research note.
TCS, analysts said, has already cautioned of structural headwinds in this vertical going forward.
In the case of Infosys, Axis Capital noted that for Infosys retail and consumer vertical was likely to remain soft with volatile performance throughout 2017-18. "Despite headwinds, opportunity exists around data analytics, legacy transformation and digital initiatives," the brokerage firm noted.
The 2016-17 performance of the banking and financial services vertical, the biggest contributor to revenues for both the companies, was hit the hardest, due to caution in spending by the large global banking and financial service clients.
For TCS, the EBIT margin from coming from this vertical, which contributed 41% of the company's revenues, declined sharply to 27.6% in 2016-17 from 29.1% in the previous year.
In its post Jan-Mar quarter results interaction with analysts, TCS tried to allay concerns for the banking and financial services vertical. The company attributed the on-quarter decline in revenue in Jan-Mar from this vertical to the closure of one project and said it was confident of pick-up in growth from Apr-Jun quarter of 2017-18 itself, according to a post-results research note by IDBI Capital.
Infosys, which had 27% of 2016-17 revenues coming from banking and financial services vertical, has said recently that it is more optimistic on the US markets given the rate hikes which it expects would lead to an uptick in budgets of banking and finance clients in Jul-Dec.
"In Europe, (Infosys) management sees opportunity from catch-up exercise by banks (they are behind the curve in tech adoption), and (from) the under penetration in Europe," said Axis Capital in its research note.
The energy and utilities vertical hit Infosys' EBIT margins hard in 2016-17 as the margin from the vertical fell to 28.7% from 29.7%.
For Infosys, margins from its hi-tech vertical also came under a lot of pressure. The EBIT margin recorded a sharp decline to 24.9% in 2016-17 from 26.6% in 2015-16. Expectations from analysts were high from this segment, but performance on the ground did not match up.
With slowdown in revenue growth being the expected norm in 2017-18, it will be the margin trajectory which will hold the key for the two largest Indian software companies.

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