TATA CONSULTANCY (2-EW, PT INR1,150, +10%): HEADWINDS AHEAD::Barclays Capital,

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We initiate coverage on TCS with a 2-Equal Weight rating and a 12-month price target
of INR1,150, based on a target P/E multiple of 17.5x. Although we like TCS, we find it
difficult to justify its P/E multiple premium of 9.5% to Infosys, and we expect this
premium to correct going forward. We also believe that TCS could now face headwinds
in margin expansion (excepted due to rupee depreciation), and hence, operating profit
growth should be largely in line with that of Infosys.
Investment summary
Strong margin performance in past three years: TCS’s strong focus on cost control led to a
400bps expansion in margins in the past three years. This has allowed TCS to close its
margin gap with Infosys to only 100bps in the June 2011 quarter. Going forward, we believe
that TCS would maintain its margins at only a 100bps discount to Infosys’s margins.
Revenue performance is commendable: For the first time in its listed history, TCS has
outperformed Infosys’s revenue growth for five quarters. To some extent, this has been led
by TCS’s strong focus on financial services (c.44% of revenues vs Infosys’s c.35%);
however, we believe the key reason behind this could be weakness in one of the large
clients of Infosys (British Telecom). Going forward, we believe that revenue growth of the
two companies could be similar, despite Infosys outperforming TCS’s revenue growth by a
CAGR of 2.6% over the past decade
Valuations appear fair: TCS is trading at a P/E of 17.2x FY2013E EPS, implying a 10%
premium to the multiple for Infosys. We believe the market is expecting TCS’s current
outperformance vs Infosys to continue. We believe that going forward, TCS’s operating
profit should grow in line with Infosys’s (despite headwinds of higher financial services
exposure) and EPS growth could be slower (largely due to tax and other income). Thus, we
base our price target for TCS on a similar multiple as for Infosys.
Valuation
Our 12-month target price of INR1,150 for TCS is based on a P/E of 17.5x, which we apply
to the average of our EPS estimates for FY2013 and FY2014, or INR67. For TCS, we apply
the same target multiple we use for Infosys given that we estimate that TCS’s operating
profit will grow in line with Infosys, although its EPS growth could be slower. Our target
multiple for Infosys is in line with Infosys’s past five-year average.
For the Indian IT vendors, we believe P/E is the most appropriate valuation method because
earnings best incorporate the two main drivers of the business: revenue growth that is a
result of new contract signings and margin resilience that comes from operational
efficiencies and position in the IT services value chain.
We rate TCS 2-Equal Weight because our price target represents only 10% potential upside
– in the mid-range of its peers – in the face of headwinds for margin expansion given our
expectation of the rupee being depreciated.
Risks
The key risks to the downside that could keep our price target from being achieved, in our
view, are a weak macroeconomic backdrop and market weakness that would cause
earnings forecast downgrades and multiple contraction. TCS trades at the highest multiple
amongst the Indian IT services peers. On the other hand, a stronger-than-expected rebound
in the macroeconomic situation poses an upside risk. TCS’s high exposure to the Financial
Services vertical means that an uptick in banks’ discretionary spending in such a situation
could mean disproportionately high gains for the company.