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Tata Consultancy Services
Overweight
TCS.BO, TCS IN
Industry leadership intact - Beating the law of
averages with yet another strong quarter
• We reiterate our long-held stance of TCS assuming P/E leadership in the
sector: TCS’ strong 3Q FY11 results (on top of an excellent 2Q FY11)
strongly confirm our long-held thesis that it is ready to take P/E leadership in
the sector at a time when the sector is experiencing exceptional demand. With
its industry-leading revenue growth, despite being more than 30% larger in
size than Infosys (its closest peer), ever-improving margin performance, and
most of all admirable consistency over the past seven quarters, we believe
TCS has decisively demonstrated that it is well poised to command premium
valuations in the industry. We believe that comparison with Infosys, its
closest peer, is now unneeded after a period of consistent relative outperformance. TCS should now be regarded as a valuation benchmark by
itself in the Indian IT industry, in our view.
• Superior sequential growth of 7.8% in the international business: The allround nature of TCS’ growth has been striking over the past 5-6 quarters
(with only telecom & enterprise solutions falling mildly short in this quarter).
• Very high employee addition attests to strong visibility for CY11: By any
yardstick, adding over 20,000 employees (gross) to the workforce in a single
quarter (over 12,000 net addition, or 7% net addition Q/Q) attests to the
strong visibility that management has on the business prospects in CY11.
• Operating margins hit an all-time high, on parity with Infosys on a likefor-like basis: It surprises us that even in a quarter in which we expected
margin headwinds due to (a) the stronger Rupee, and (b) steeply higher rent
costs, TCS has scaled yet another peak in operating margins (28.1% EBIT).
This represents the culmination of a process of continual improvement in
operating margins, which have risen by over 600bp since 1Q FY09. EBIT
margins now stand within 210bp of Infosys’ and, adjusted for TCS’ exposure
to the India market (over 9% of revenues), where margins are much lower, we
estimate margin parity on the overseas (export) business with Infosys.
• Investment view: Likely to lead the sector on valuations; maintain OW
with new Sep- 11 PT of Rs1,280: Yet again, we raise (a) our FY11E/12E
EPS by 4%/7% and (b) our price target (from Rs1,150), ascribing a target
valuation that is at a premium to that of Infosys. TCS remains our top pick
among the large caps, and we continue to recommend TCS (OW) over
Infosys (N), believing it will return an extra 7-10% over Infosys on a 12-
month horizon, with much of this front-ended
Environment outlook continues to improve, margins look
sustainable
Management sounded confident about the environment, indicating closure in clients’
IT budgets for CY11. While the macro-environment caveat was repeated, the on-theground impact for offshore IT services players remains positive across verticals and
service lines. Moreover, management also clearly indicated that the demand was not
just pent-up demand and is more sustainable in nature, which we think points to
improved and sustained visibility in the IT spend outlook and a potential increase of
better-margin discretionary projects. The deal pipeline continues to look strong for
the coming quarters, as evidenced by the very robust hiring numbers.
On margins, management expects to hold on to margins using cost-control measures
to offset the sharp rupee appreciation. We think this is appreciable given the already
strong margin performance in 1H FY11 – despite the wage rises, stronger rupee, and
higher rent and travel expenses.
3Q FY11 Highlights
• Revenues came in at Rs97 billion, up 4.1% Q/Q and up 7.0% in US$ terms
($2.14 billion), driven by strong 5.7% Q/Q volume growth and positive
pricing (+1.2%). Volume growth has understandably moderated from 11.2%
last quarter. International business registered 7.8% growth. Forex headwind
of 1.7% and increased offshore leverage (-1.1%) diluted the US$ revenue
growth to 4.1% Rs growth.
• Pricing improved modestly and contributed about 118bp to the top-line
growth.
• Revenues from the top 5 clients were up 6.0% (in US$ terms). Revenue
growth from top 10 clients was 7.0%, in line with growth from non-top-10
clients. The top 10 clients contributed 30.1% of total revenues.
• Proportion of fixed price contracts increased to 49.7%, the highest ever for
the company, after remaining at about 49.0% for two straight quarters.
• Revenues from BFSI increased 8.4% Q/Q in US$ terms. Media and
Entertainment revenues increased 23.0%, Hi-Tech grew 16.3% Q/Q,
Transportation increased 13.7% Q/Q, Energy and Utilities grew 9.5% and
Healthcare reported above average growth of 9.1%. Telecom continues to
be a drag (contracting 0.5%), primarily due to weakness in the domestic
market, where a large proportion of revenues come from discretionary
spending. Manufacturing growth at 4.1% was muted as well.
• TCS reported net addition of 12,497 employees during the quarter, which is
the highest ever for any single quarter (7% Q/Q net addition). Gross
addition was 20,219.
• Attrition increased modestly (30bp) to 14.4% (LTM) driven by increased
BPO attrition (24.7% compared to 22.5% last quarter), while IT Services
were almost flat at 13.2% (from 13.1% in 2Q). On an absolute basis,
attrition declined 10% Q/Q from 8,576 in 2Q to 7,722 in 3Q.
• TCS added 35 clients during the quarter. Net increase in million dollar
clients was 14, compared to just one last quarter. TCS won nine large
deals during the quarter.
• Utilization (excluding trainees) remained flat at 83.8%, but decreased
slightly including trainees to 77.1% from 77.7% last quarter due to
increased number of trainees. The strong utilization is in agreement with
our view that the 'new normal' for utilization should be higher than
historical average.
• UK and Continental Europe revenues (in US$ terms) grew at 11.9% and
9.3%, respectively. North America was also strong with 6.6% growth. Latin
America and domestic revenues witnessed a decline of 15.0% and 0.6%,
respectively. AsiaPac (+19.1%) and MEA (+12.6%) regions also exhibited
double-digit growth.
• By Horizontals, Asset leverage solutions (+25.9%), Infrastructure services
(+19.5%), Global consulting (+17.2%), Assurance services (+15.1%) and
BPO (+11.1) reported double-digit Q/Q growth, while Enterprise solutions
(-0.3%), Business intelligence (+1.3%), ADM (+2.9%) and Engineering
services (+4.8) remained relatively weak.
• Although discretionary spending did not grow in line with the company
average in 3Q FY10, indicated by the fact that BI, Enterprise solution,
Engineering services and consulting revenues grew only 2.8% Q/Q,
management expects discretionary spending to pick up in the coming
quarters.
• Gross margins and operating margins improved by 26bp and 7bp,
respectively, as currency headwinds were more than offset by SG&A
improvement and positive offshore leverage. The continuous
improvement in operating margins reinforces our belief that the
greater-than-historical average margins are due to a positive structural
shift.
• Tax rate for 3Q was 18.6% (18.9% in 2Q) and management guided for
continued increase in tax rate due to businesses moving out of STPI regions.
Management expects FY12 and FY13 tax rate to be 23% and 25%,
respectively.
• DSO stood at 80 days, increasing from 78 last quarter. Invested funds were
$85.7 billion at the end of 3Q, an increase of $14.0 billion from 2Q.
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