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Walking the talk
TCS’ robust 3QFY11 results are triggering a 0.3-2% earnings upgrade on
our top of the street FY11-13 estimates. While 7%QQ $-revenue growth
was a tad below estimates, gross hiring of over 20,000 indicates that TCS
is planning for a big 2011 ahead. 28bpsQQ improvement in gross margins
despite adverse currency move indicates TCS’ strong focus on cost
containment under the new dispensation. We see the TCS report
increasing investor confidence on sustainability of Indian-tech order
books through 2011. While TCS results will no doubt boost the sector
sentiment, our preference lies with TCS and Infosys, where we see
sector-leading revenue growth and solid margin performance.
Hiring and capex trends indicate planning for a robust 2011
TCS’ 3Q $-revenue growth of 7%QQ (7.8%QQ in international business)
came in-line with street expectations but a tad below our street high estimate
of 8.1%QQ. The most important investment indicator in the current
environment remains the hiring pattern and those indicators are flashing
green. Record gross hiring of over 20,219 people (Over 7,700 lateral hires) in
the quarter (after hiring 19,293 people in the previous quarter) indicates that
TCS is preparing for a big year ahead in 2011. Importantly, TCS has met its
FY11 hiring guidance of 50,000 in just 3 quarters and will now be hiring
additional 12-15K employees in Mar-11 quarter. 31%QQ increase in capex to
Rs4.5bn for capacity expansion is also reflective of the planning for growth.
Giant strides continue on margin management
EBIT margins were up 7bpsQQ despite adverse impact of currency
appreciation. A higher revenue throughput, increased offshoring, bad debt
write-back and lower hardware pass-through revenues aided margin defence.
With currency looking benign and select price increases (especially in new
business) coming through, we expect further margin upsides through 2011.
In our view, TCS' margin improvement is structural and driven by multiple
things that the TCS management has been working - such as closing down
sales offices, consolidating delivery centres, raising sales productivity (it had
too many customers paying <$1m in annual revenues - long tail - being
improved) and linking sales incentives more intricately to profitability.
Cementing its status as the key investment idea in Indian Tech
The street has upgraded TCS’ earnings in 6 out of the last 7 quarters and that
trend will likely sustain in the near term. TCS continues to show urgency in
reducing operational flab and is steadily closing the margin gap with Infosys,
while inching ahead on revenue growth. Through FY12, we expect TCS to
consolidate the operational gains made in FY10/FY11 driving further margin
upsides, even as revenue growth remains strong.
What is driving the margin beat?
TCS has surprised the street positively on margins for the 7th consecutive
quarter now. In our view, the margin improvement is structural and driven by
a number of key operational factors.
Factor #1: Increased sales productivity
The key to controlling SG&A costs is increasing wallet-share within existing
clients as costs of mining existing clients are always lower than hunting for
new clients. Moreover, managing a very long tail of clients (which pay less
than US$1m) demands greater sales effort. Historically, TCS used to have
almost 60% of its clients paying less than US$1m in revenues. Over the last
11 quarters, that proportion has come down significantly. Importantly,
number of clients paying less than US$1m has remained constant even as the
total client strength has gone up almost 75. This is symptomatic of the
greater focus on mining clients which in itself has led to improved cost
management. TCS has also substantially improved on revenue per client
metric and is currently at US$9m, a greater than 50% jump from the recent
bottom in Mar-09 quarter. TCS’ productivity per sales office has even as
number of sales offices is down to 142 from a peak of 169 five years back.
Factor #2: Effective control of manpower costs
Since its peak in Dec-08 quarter, TCS has reduced per employee quarterly wage cost by almost
10.5% to Rs1.19m despite giving wage hikes and stepping up the variable
pay. We expect this to go down further through the year as younger and
cheaper manpower joins TCS. Three key factors have aided this decrease in
per capita wage costs:
‰ Rationalisation of non-billable staff: Until 2008, TCS used to have a
significant portion of non-billable manpower (pre-sales, alliance teams etc)
in onsite locations. These inefficiencies were somewhat covered by the
high revenue growth. However, the demand slowdown in 2008, forced
rationalization of these costs and most of the non-billable staff was relocated to India through 2009. This has helped reduce wage costs.
‰ Increased offshoring: With cost-cutting becoming the over-riding
priority for most clients, offshoring propensity of clients has increased and
is reflected in the increasing proportion of offshore revenues at TCS. This
has further helped reduce per capita manpower costs.
‰ More effective use of variable salary: When the demand picked-up in
mid 2009, TCS was the first to step-up variable pay. While Infosys started
paying out 100% of eligible variable pay only in FY11, TCS made this
change in early FY10. These measures have ensured that attrition at TCS
is the lowest in the industry driving better resource planning and also
precluded the need to substantially raise base salaries. Contrast this with
peers Infosys and Wipro, where there have been two rounds of wage
hikes/promotions to stem attrition.
The above steps have meant TCS’ (manpower costs/revenue) ratio has gone
down steadily. Jun-10 quarter is an aberration due to the wage hikes but
despite since then TCS has managed the ratio very well.
What makes us confident of robust growth in FY12?
A look at the TCS hiring numbers is makes us confident that TCS is planning
for block-buster growth in 2011. Gross hiring of 50,361 in 9MFY11 has meant
TCS has exceeded its FY11 gross hiring targets in 9 months itself. TCS intends
to hire 12-15K more employees in the 4th quarter.
TCS is also backing its hiring with significant investments in capacity
expansion. Capex in 9MFY11 is up 64.7%YY to Rs10.97bn. Gross block in
buildings is up 14% by US$60m through FY11. Capex in Dec-10 quarter itself
is up 31%QQ to Rs4.5bn and we expect a step-up here as well.
Demand up-tick flowing through to the bottom-line
Unlike in Infosys where the topline upside has somehow not flown fully to the
bottom-line (driven by margin downside as well as tax rate spikes), TCS has
managed to convert its revenue beat into earnings. The street has upgraded
TCS’ estimates in 6 of the last 7 quarters (including Dec-10).
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