India IT Services -Concerns over dip in cash flows unwarranted as long as ROIC is high; JPMorgan

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India IT Services
Concerns over dip in cash flows unwarranted as long
as ROIC is high; the trade-off needs to be made in
favor of earnings growth using ROIC as a cushion


• We believe the debates regarding cash flow performance of TCS versus
Infosys are unwarranted and even pointless. TCS, in fact, has delivered
better free cash flow (FCF) and operating cash flow (OCF) performance in
FY11, together with superior revenue growth and sustained profitability. TCS’
operating cash flows are down only 6% Y/Y in FY11 (in US$ terms), while
Infosys' OCFs are down 11%. Similarly, TCS' FCF decreased 18% Y/Y, while
Infosys' FCF declined 23% in FY11. TCS has fared better than Infosys on both
operating and cash flow parameters in FY11 largely because of its growth. As
% of revenues, OCF and FCF tend to be lower in growth periods as companies
invest for growth (Refer to our report dated Jan 28, 2011 “Concerns over slipup
in working capital and cash flow performance in Indian IT overdone; this is
a consequence of growth and tougher YoY comparison”).
• The gap between Infosys' and TCS' total DSO (based on billed and unbilled
receivables as days of sales) is at an all-time low, pointing to incrementally
better balance sheet management by TCS. The difference is down to ~12 days
decreasing from about 24 days in 2QFY10. However, we do not believe that an
increase in DSO is essentially bad for a company, as long as it helps top-line
growth and is within limits. Spread-out payment terms to clients can result in
better relationships with quality clients. Noticeably, Infosys’ unbilled revenues
increased 44% in FY11 compared to FY10, while TCS unbilled revenues
increased only 4% which points to the improving quality of TCS earnings and
slight adverse movement of Infosys’ DSO (in FY11).
• Developing growth strategies judiciously drawing on ROIC need not
compromise margins as TCS has admirably shown. It’s not a growth versus
margin debate but a growth versus ROIC debate. This is because ROIC is
not only a function of margins and profitability but also of how firms manage
their balance sheet. If vendors concede concessions to clients that entail initial
investments (data-centres for example), or back-loaded cash flows or relaxed
payment terms, all of these are likely to impact the balance sheet. There is
benefit in doing this to drive earnings growth if firm’s existing ROIC is already
high. Our valuation framework suggests that the stock returns are a rather weak
function of ROIC (than of earnings) if ROIC is already above a comfortable
threshold benchmark (~ 30-35%). (Refer to our report dated April 7, 2011, “The
growth versus ROIC debate is an old one but is alive and kicking”).
• TCS’ ROIC at 40%+ allows it to trade in favor of earnings growth without
affecting margins. In this context, concerns over TCS’ operating and free cash
flow performance in FY11 (declining 6% and 18%, respectively, over FY10)
despite creditable FY11 EBIT Y/Y increase of 35% (in US$ terms) are
unwarranted. Interestingly, TCS' ROIC at 43%-44% did not increase over the
last two years even as its EBIT margin expanded by 600 bps signifying that TCS
recognizes the benefits of using the balance sheet (through balance sheet-related
investments) to drive higher margins, earnings growth and investor returns.
• Investment view. We remain OW on TCS, Wipro and HCL Technologies. TCS
and Wipro are our key picks. We remain Neutral on Infosys